Ask Brian: What Advanced Tax Benefits are Available to Real Estate Investors? (2024)

Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to [emailprotected].

Question from Elizabeth in MS: Hello Brian, I have a full-time job with a part-time real estate investment business on the side. I rent out three single-family homes that I’ve purchased over the past eight years. I’m getting ready to look for a fourth rental house to purchase. I decided to try a trial membership with a local investment club to do a little networking and see if I can find a good deal on my next investment. At my first meeting, I got talking to a guy with a table offering a course on Rental Property 1031 Tax Exchanges. I do my own tax returns and thought I had all my tax bases covered. But I’ve never heard of a 1031 Tax Exchange. At the same meeting, I talked to another guy about this tax break and he mentioned another possibility is investing through a Solo 401k retirement account. To say the least, I got my money’s worth from the trial membership. Now, I’d like to learn more before I make my next investment.

Answer: Hello, Elizabeth. The 1031 Exchange and Solo 401k are both powerful tax benefits but they do have limitations. One or the other might work for you depending on your long-term plans and the direction that you want to go in with your portfolio. But first, congratulations on seeking out new wealth-building opportunities that come with networking.

The 1031 Exchange gets the name from Section 1031 of the IRS code. The first thing you need to know is that it requires you to sell one of your investment properties and buy another one of equal or higher value. That won’t work for you if you are planning to just add another property to your portfolio. On the other hand, it could be the perfect tool if you want to do something like selling one of your houses to invest in a property that generates more income. Say a duplex or four-unit apartment building. You could certainly go larger when using a 1031 Tax Exchange but anything larger than four units is considered a commercial property with more complexity.

There are four variations to the 1031 Tax Exchange, so I’m only going to cover the basics here. If you want to learn more about the variations, you could take the course from the guy that you met or you could probably save some money if you buy a book and talk with a real estate tax professional.

The basic idea of a 1031 Tax Exchange is that when you sell a business or investment property, you have a capital gain - you owe tax on the gain at the time of sale. Section 1031 of the tax code allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying ‘like-kind’ exchange. Your big advantage is that you can use the money that you would have paid in taxes as part of your payment for the larger property. This is a tax deferral, meaning that you will have to pay the tax eventually, but the fact is that might not be until after you are dead and gone. As you continue to build your portfolio, you can defer the capital gain tax if your purchases are for equal or higher value properties. Elizabeth, the biggest downside for you might be the requirement to sell one property to buy another. This can be a deterrent if all your properties are well-managed and producing a healthy income. Another deterrent could be if you have a goal to own all your properties outright and don’t want to finance a future purchase for more expensive property. Also, something to be keenly aware of is strict timelines that apply. For instance, identifying potential replacement properties within 45 days of the sale of the relinquished property and completing the purchase of the replacement property within 180 days. If you miss any of the critical deadlines, the IRS will disqualify the 1031 Exchange. The good news is that there are four variations to the 1031 Exchange. You’ll want to be familiar with each before making a decision.

1. Delayed Exchange – most common.
2. Reverse Exchange – allows you to purchase the replacement property before selling the relinquished property.
3. Simultaneous Exchange – not as common but can work if two investors literally trade properties, which is what an ‘exchange’ originally meant many years ago.
4. Improvement Exchange – also less common but can be preferred when the investor needs to improve the new property before taking possession.

Real estate investing with a Solo 401k retirement account is a very different animal. But investing in real estate is an extremely popular option because Solo 401k accounts are about alternative assets other than Wall Street stocks and bonds, which is what almost every employer-based 401k retirement account is limited to.

There are two basic types of Solo 401k accounts. The traditional Solo 401k uses the IRS tax code to defer taxes until withdrawals begin (usually after retirement). What’s different from the 1031 Exchange is that you are deferring your income taxes instead of capital gain taxes (you can also defer capital gain taxes). But again, those deferred taxes give you more money to invest with and grow your earnings faster. The biggest hurdle is that you must be self-employed, and you can’t have any employees. You can hire contract labor, but you can’t have employees directly on your payroll.

Elizabeth, you’re already a real estate investor, which qualifies you as self-employed. Your rental income can be taxed deferred into a Solo 401k. What you need to be aware of is that you won’t be able to place your existing rentals in a Solo 401k. There is an IRS rule that prohibits what they call ‘self-dealing’ (there are similar rules that apply to some family members). The concept is that you and your Solo 401k are entirely different business entities that can’t directly do business with each other. You can defer your current income taxes as contributions to your Solo 401k but once the money is in the Solo 401k you can’t directly profit from it until you begin taking withdrawals. There are a few simple rules that you’ll need to learn about self-dealing. Although you can’t put your exiting rentals into a Solo 401k, it’s possible your next purchase and future purchases can go into a tax-deferred Solo 401k. The key is that you must set up the Solo 401k first and title your next house in the name of your Solo 401k. This could be an excellent option if you’re comfortable with your current income and want to seriously begin funding your retirement account. A Solo 401k is also an outstanding way to build wealth.

The other type of Solo 401k is a Roth Solo 401k. The same self-dealing rules apply but it has a different tax structure. Instead of deferring your current income taxes, you pay the taxes before you make the Roth Solo 401k contribution. The tax advantage is that all the earnings that grow over the years will be tax-free when you begin taking withdrawals after retirement. For instance, the income from two rentals in a Roth 401k could be used to buy a third rental house (or fourth or fifth) and you would never owe taxes on the income from any of those houses. A Roth Solo 401k tends to work best for younger investors with many years to grow the earnings and people that expect to be in a higher tax bracket during retirement.

Elizabeth, doing your own taxes when you are a real estate investor can be admirable, but it might not be serving your best interests. You may want to work with a real estate tax professional at least every few years. Especially in years when you will be buying or selling a property.

What other tax benefits do you want to make investors aware of? Please add your comments.

Our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions or inquiries to [emailprotected].