Many active service members and veterans use their VA loan benefits to purchase homes. And, when these same individuals move, many decide to rent out their homes. In this way, it’s common for service members to end up as real estate investors. But, this transition can have major tax consequences when people sell their rental properties. Fortunately, the 1031 exchange offers a means to reduce this tax burden. As such, we’ll use this article to explain 1031 exchanges as a military investor.
Specifically, we’ll discuss the following:
- Capital Gains: Primary Residence vs. Investment Property
- 1031 Exchange Overview
- Using the 1031 Exchange as a Military Investor
- Final Thoughts
Capital Gains: Primary Residence vs. Investment Property
Generally speaking, when you sell a significant piece of property (e.g. real estate, automobiles, collectibles) for more than its original cost, you have what’s called a capital gain. For example, say you buy a car for $10,000 and sell it for $15,000, you would have a capital gain of $5,000. And, the IRS wants a piece of that gain. Accordingly, individuals generally must pay a capital gains tax on this income. Depending on how long you hold the underlying asset, you’ll either pay a short-term capital gains tax (at your marginal tax rate) or a long-term capital gains tax (at a more advantageous rate of 0%, 15% or 20%).
With real estate costing hundreds of thousands of dollars (or more), these gains can potentially come with huge capital gains tax bills. But, before panicking about selling your home, it’s important to understand that the IRS treats primary homes differently than rental properties. While the terms primary, principal, rental, and investment all get thrown around among property owners, it’s important to understand that the IRS has specific definitions – and tax treatments – for different residence types.
- Principal (a.k.a. primary) residence: This is your actual home, that is, the place where you live for the majority of the year. The IRS provides certain tax benefits (capital gains exclusions, mortgage interest deduction, etc.) associated with these properties.
- Investment (a.k.a. rental) property: This is an income-producing property, that is, the homeowner acts as a landlord and rents the property to tenants. Income and expenses related to these properties are treated like business expenses and reportable on a taxpayer’s Schedule E.
To encourage homeownership, the IRS provides a significant capital gains exclusion for primary residences. In other words, most homeowners will not need to pay a capital gains tax when they sell their primary homes for more than they purchased them.
However, this exclusion does not apply to rental properties. Accordingly, when service members and veterans acquire portfolios of rental properties, they will potentially face significant tax bills when they sell these properties at a gain.
1031 Exchange Overview
Fortunately, the IRS offers a way to defer these capital gains taxes on rental property sales. With a tax deferral, you still owe the taxes, but you don’t have to pay them now. That is, you delay – or defer – the payments until a future tax year. While multiple tax deferral strategies exist, one common strategy applies to real estate investors: the Section 1031 like-kind exchange, or 1031 exchange, for short.
With a 1031 exchange, real estate investors can roll the capital gains from the sale of one property into the purchase of another. By doing this, these investors defer the taxes on the first property until they sell the second property. Alternatively, you can do a second (and third, and fourth, etc.) 1031 exchange, rolling the capital gains from the first and second properties into the third property.
For example, say you purchase a rental property for $200,000 and sell it five years later for $300,000. In this scenario, you’d have a taxable capital gain of $100,000 (NOTE: for the sake of simplicity, we’ll ignore the effects of depreciation and transaction costs in this article). Normally, you’d need to pay a capital gains tax on that $100,000 gain. But, if you conduct a 1031 exchange, you could roll that $100,000 gain into the purchase of a new property, thereby deferring – or delaying – your tax bill.
In this fashion, you can maximize your return on investment, rolling all of your sales proceeds into new properties (as opposed to only using the net-of-tax proceeds). Say, for instance, you fall into the 15% long-term capital gains tax bracket. Using the above scenario, you would owe $15,000 in capital gains taxes when you sell your rental property ($100,000 capital gain x 15% tax rate). This means that, by executing a 1031 exchange, you’d have an extra $15,000 to purchase a new rental property. With an 80% loan-to-value (LTV) mortgage, that’s an additional $75,000 in purchasing power!
Using the 1031 Exchange as a Military Investor
For military real estate investors, two common 1031 scenarios exist:
Scenario 1: Primary Home to Rental Property Conversion
As discussed in the introduction, many military members become landlords incidentally. That is, you use your VA loan to purchase a home, live in it for a few years, then PCS to a new base. Rather than sell this home, you decide to rent it out, converting a primary residence into an investment property.
Eventually, it’ll make sense to sell this first property. Due to its conversion to a rental, you’d normally need to pay capital gains taxes at sale. However, if you instead opt to conduct a 1031 exchange, you could purchase a new rental property with the sales proceeds, deferring your capital gains taxes in the process.
Scenario 2: Purchasing an Investment Property
Alternatively, some service members decide to purchase pure rental properties, that is, homes that you rent out immediately rather than personally occupy. For instance, say you get stationed in Norfolk, Virginia and, after living in the area for a period of time, decide that it has a strong rental market. As such, you purchase a home as an investment property.
Ten years later, the home you purchased for $150,000 is now worth $300,000. To take advantage of this appreciation in value, you decide to sell your investment property. Normally, selling this home would lead to a capital gains tax on the $150,000 gain. But, with a 1031 exchange, you can use these sales proceeds to purchase a new property and defer your tax bill.
This move can lead to a huge return on your initial investment. Let’s say that, in the sale, you net $200,000 pre-tax. With an 80% LTV mortgage, you could use this money as a down payment to purchase a $1,000,000 multifamily property. In ten years, you’ve now taken the $30,000 down payment on the first home ($150,000 x 20%) and converted it into a $1,000,000, income-producing property.
Yes, these are simplified examples. But, the key takeaway is the value that 1031 exchanges bring military real estate investors.
Consider this article a brief introduction to 1031 exchanges. Due to the potential for abuse, the IRS imposes strict compliance requirements on the 1031 process. Accordingly, you’ll need to work with a tax professional – ideally one specializing in 1031 exchanges – to execute such a deal. But, the tax savings and ability to scale a rental property portfolio often makes this extra work more than worth the effort.
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.