The Lazy 1031 Exchange: Effortless Way to Defer Huge Taxes

This article is for you if you’re a real estate syndication (passive) investor looking for ways to defer taxes and offset capital gains.

If you’re not sure what a syndication is, check out this video:

The answer is something called the Lazy 1031 Exchange.

This tax strategy involves selling a property (or exiting a syndication) and investing in a new one in the same calendar year. Cost segregation study and bonus depreciation are applied to mimic a 1031 exchange without its complexities effectively.

Imagine exiting a syndication and not worrying about finding a similar one within a strict timeframe.

In this article, you’ll explore how the Lazy 1031 can fit perfectly into your investment strategy, providing you with potential tax savings and more flexibility.

As a side note, I’m a periodontist (NOT a CPA), so don’t take anything from this article as tax advice. If you want a really good CPA who knows real estate, here’s a link to mine for a free strategy call.

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What is a 1031 Exchange?

Before we get started, let’s first define what’s involved with a “regular” 1031 exchange.

Section 1031 of the Internal Revenue Code allows you to exchange one piece of real property for another without triggering immediate taxes on capital gains.

For example, if you sell a rental property or exit a syndication and buy a similar one, you defer the capital gains taxes.

Both properties involved must be like-kind, meaning they’re similar.

Residential, commercial, and even certain types of vacant land can qualify.

There are strict timelines for completing these exchanges. Once you sell your property, you have 45 days to identify a replacement and 180 days to complete the purchase.

Missing these deadlines disqualifies the exchange, making it crucial to plan ahead.

Role of Qualified Intermediary

A Qualified Intermediary (QI) is essential for a successful 1031 Exchange.

The QI holds the sale proceeds and ensures you never touch the funds, maintaining compliance with IRS rules.

They prepare the necessary documents and coordinate the process to ensure all timelines are met and the exchange meets IRS requirements.

Their role is to handle paperwork, deadlines, and funds safely, so you can focus on finding the right replacement property.

Not using a QI or having an unreliable one can jeopardize your exchange and result in losing tax benefits.

Understanding Depreciation Recapture

Depreciation recapture is an important aspect often overlooked. When you sell a property, the IRS demands you pay taxes on the depreciation claimed during ownership, known as depreciation recapture.

This can significantly increase your tax burden on the sale.

A 1031 exchange can defer these taxes along with capital gains taxes. By exchanging properties, you avoid paying immediate taxes on depreciation recapture so long as the proceeds are reinvested in another like-kind property.

However, if you eventually sell without using a 1031 exchange, you’ll need to address these deferred taxes, including depreciation recapture, which will impact your tax liability at that point.

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The Lazy 1031 Exchange

A Florida dentist (member of our Passive Investment Circle) contacted me regarding advice on tax strategies as he was preparing to exit one of our RV park syndications. As you can imagine, he was concerned about the potential tax hit he’d face from his gains.

He had previously spoken to his CPA, who told him that sometimes, when you’ve made significant gains on an asset, you have to accept and pay the taxes. He didn’t want to hear this; he felt that paying a firm big money each year could do better.

When he contacted me, and I mentioned The Lazy 1031, he said he’d never heard of that strategy but liked the idea of being “lazy” and not paying taxes! 🙂

How Does It Work?

During our conversation, I explained the strategy that he benefits from significant tax advantages as a passive investor in real estate syndications, especially RV parks, through bonus depreciation and cost segregation.

Essentially, bonus depreciation allows him to deduct 100% of the depreciation in the first year of an investment rather than over the asset’s entire expected life. Cost segregation involves an engineering firm analyzing the property and segregating its components into different depreciation rates, which enables more depreciation to qualify for bonus depreciation.

The result is that both the asset and the passive investor receive a much larger paper loss in the first year. This loss can offset passive gains from real estate, including cash flow and capital gains.

However, taking all that depreciation in the first year means you’ll eventually have to “recapture” it when you sell (as previously mentioned). Thus, the strategy works best when you reinvest in new deals and restart the cycle.

Bonus Depreciation Example

Let’s say I invested $200,000 in an RV park syndication and sold it several years later for $300,000, resulting in a $100,000 capital gain. Assuming my accountant used straight-line depreciation, there would be some depreciation recapture, but we’ll ignore that in this example for simplicity.

If I did nothing, I would have to pay tax on the $100,000 gain. At a 20% capital gains tax rate, that’s $20,000 in taxes, leaving me with $280,000, including my original capital of $200,000.

However, if I reinvested the $300,000 into another RV park syndication that used bonus depreciation and cost segregation, I would have a paper loss in year one.

Assuming a 50% passive loss from bonus depreciation, I would have a $150,000 paper loss, completely offsetting the $100,000 gain from the property sale. Additionally, I would carry over $50,000 of passive loss into subsequent years until it’s used up.

If I earned an 8% cash-on-cash return on the $300,000 investment (which is what most of our syndications have averaged), I’d make $24,000 per year.

Related article: Cash On Cash Return Formula: Are You Making Money In Real Estate?

My cash flow would be tax-free for the first two years, offset by the $50,000 carryover losses. In this example, I deferred the entire capital gain from selling the RV park and deferred paying tax on the first two years of cash flow.

The Golden Hamster Wheel

The beauty of this approach is its ongoing benefit as long as you keep investing, similar to the regular 1031 Exchange. If the RV park mentioned above is sold after five years, and my $300,000 investment returns a total of $600,000, I would have a $300,000 capital gain and a $150,000 depreciation recapture.

If I reinvested the $600,000 into another syndication in the same calendar year using cost segregation with a 50% bonus depreciation, I’d have a $300,000 loss, offsetting the gain entirely. I would still have the $150,000 depreciation recapture with two options:

• pay the recapture tax at a 25% rate or…
• use additional passive losses from other syndications to offset it.

Some investors refer to this as the “Golden Hamster Wheel.”

When starting passive real estate investing, it’s common to accumulate significant passive losses carried forward into future investments. Gains typically come later. If you invest $200,000 in two syndications in your first year, you might have $100,000 of passive loss and only $16,000 of cash flow (each having an 8% preferred return).

Investing $200,000 in similar deals in each of the next two years adds another $200,000 of passive losses and $32,000 in cash flow.

After three years, you would have $300,000 of passive losses and $48,000 of passive income. The $48,000 cash flow is offset by some of your loss, leaving $252,000 of passive losses.

These suspended passive losses can be carried forward indefinitely. When some investments go full cycle and sell, these unused passive losses can offset gains, making the strategy powerful—continuing to invest in new deals accumulates passive losses to offset cash flow, capital gains, and depreciation recapture in the future. Reinvesting gains into new syndications can continually defer and reduce taxes.

Conclusion

There are various ways to reduce or defer tax liability in real estate investing, but few are as simple as the “Lazy 1031.”

If you’re not keen on the strict timelines and active investing required by a traditional 1031 Exchange, the “Lazy 1031” might be an effective strategy.

Frequently Asked Questions

What are the specific rules governing a 1031 exchange?

A 1031 exchange, named after Section 1031 of the U.S. Internal Revenue Code, requires you to reinvest profits from selling one property into a “like-kind” property.

Both properties must be used for business or investment purposes. The exchange must be completed within 180 days.

What are passive real estate investments?

 Passive real estate investments are those in which investors contribute capital to a real estate project without being involved in the day-to-day management or operations. This type of investment allows individuals to benefit from real estate profits and tax advantages without the active involvement required by direct property ownership.

How does a 1031 exchange impact passive investment strategies?

A 1031 exchange can significantly benefit passive investors by deferring capital gains taxes.

This allows you to maximize the returns on your real estate investments without the need for active management.

The “Lazy 1031” approach especially simplifies the process, making it more accessible.

Can you provide an example of how a 1031 exchange typically works?

You sell an investment property for $500,000 and use the proceeds to buy another like-kind property within 180 days.

By doing this, you defer paying capital gains taxes on the sold property until you sell the new property.

What are potential downsides or disadvantages of participating in a 1031 exchange?

The complexity and strict timelines can be challenging.

You may also be pressured into purchasing a replacement property quickly, which might not always be a good investment. Additionally, future tax laws could change, impacting deferred gains.

Are there alternatives to a 1031 exchange that may offer similar benefits?

Yes, other strategies such as Opportunity Zone investments and Deferred Sales Trusts can offer tax deferral benefits. However, these options may provide similar advantages but come with their own set of rules and requirements.

What should a buyer be aware of when considering a property involved in a 1031 exchange?

Potential buyers should understand the property’s background. This includes why it’s being sold and the time constraints involved in a 1031 exchange.

Ensure that the property meets all investment criteria. Also, make sure that you’re not rushing into a purchase due to exchange deadlines.

How does investing in a new syndication help with tax cuts?

Investing in a new syndication can provide tax cuts through mechanisms like bonus depreciation and cost segregation, which create large paper losses. These losses can offset gains from other investments, deferring taxes and increasing overall investment returns.