Can You Use a 1031 Exchange Out-of-State?

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A 1031 exchange refers to the Internal Revenue Code, Section 1031. This code allows you to defer capital gains taxes from the sale of a property by “exchanging” it for another property of equal or greater value. A 1031 exchange is also known as the like-kind exchange.

But what happens if you live in a large city and the market isn’t ideal or profitable? Can you use a 1031 exchange out of state? The answer is yes.

The IRS 1031 code is a federal tax code recognized in all states. Purchasing like-kind property in another state is commonly known as a state-to-state 1031 exchange. 

Learning all you can about how a 1031 exchange works to leverage a profitable and smart investment strategy for earning capital and planning your estates is a wise decision.

In this article, I’ll explain why you should invest in properties out-of-state and the best practices of using a state-to-state 1031 exchange. 

Why You Should Invest With A 1031 Exchange Out-of-State

Since a 1031 exchange is accepted federally, there are few limitations to purchasing property in a state outside of where you reside. However, some states have tricky rules, so make sure to speak with a local broker in the area you’re looking to buy. It’s wise to research the area to understand the market and local laws and regulations. There are several reasons an investor would want to purchase an out-of-state property, each depending on personal goals and preferences. I’ve listed the top four reasons to invest in out-of-state property.

1. Improve cash flow

Capital gains taxes are deferred when using a 1031 exchange to purchase property, meaning a more significant percentage of the proceeds can go towards your new investment. If the market in the city or state you live in isn’t performing well, you might not find a profitable property that allows enough cash flow.

Suppose you have a property in California where you know you could sell for top dollar. The issue wouldn’t necessarily be selling the property; it would be finding a like-property that would increase your profits. In that case, you could sell the California property and purchase a larger single-family property, multiple small to mid-size properties, or a multi-tenant apartment complex in another state. Suddenly, you’ve expanded your portfolio and increased your cash flow from selling one property.

When you sell a property using a 1031 exchange, any additional capital from the sale can roll over into other properties. This allows you more cash flow to continue investing in multiple properties, collect rent, and put more money into the bank.

2. Reset the depreciation clock on your asset

Another benefit of investing out-of-state with a 1031 exchange is that it can reset the depreciation clock on your asset. You’ll be able to buy a new property and take advantage of depreciation to offset your income. This can add up if you’ve held onto a property for several years.

When you sell a property above depreciated value, the difference between the selling price and the tax basis must be reported as taxable income. In other words, you’ll have to recapture the depreciation. However, you have the potential to reduce the amount of income taxes you pay because of depreciation. Cut down on taxes and save more money. 

3. Level up by exchanging for higher-value properties

1031 exchanges have few limits or caps on investments. This allows investors to start with a modest property and, over time, level up for higher-value properties. You can take profits from multiple single-family homes in a hot seller’s market and purchase multi-family or commercial property in an up-and-coming area with less competition. 

Because you can use a 1031 exchange for up to 10 single-family homes, many investors living in highly appreciated, high-tax states like California and New York will often use this as an opportunity to build an extensive portfolio of rental or commercial properties in less fickle markets. Doing this creates more cash flow, generating greater returns over time.

4. Diversify your portfolio

Get exposure to new markets and diversify your investment portfolio by purchasing property in markets that are up and coming. Getting a head start in an up-and-coming market could lead to more significant returns down the road. As mentioned above, using a 1031 exchange will allow you to defer capital gain taxes when selling a property in a high-tax seller’s market. You can then take that capital and diversify your portfolio with various passive investments in an up-and-coming market with more affordable properties. This will spread out any risk and provide higher returns on investment.

Best Practices

Jumping into an out-of-state investment without taking the proper precautions can lead to unwanted headaches. It’s essential to think carefully about your investment goals and what type of properties you want to pursue. Here are a few best practices for investing out-of-state through a 1031 exchange. 

Follow the rules

Any investment will always have a set of rules or best practices. This is even more so when using a 1031 exchange because specific regulations must be followed. It could cost you big time if you don’t follow the rules. 

Build a solid team

Building a trustworthy team is always a good idea when investing in real estate. Even more so when you’re investing out-of-state because you’re not close by to drop in. You must build a collaborative, knowledgeable, communicative, and trustworthy team. These are the main people you’ll want on your team. 

• A local real estate broker 
• Qualified Intermediary (QI)
• CRE attorney
• Tax specialist
• Property manager

Do your research: Before you begin searching for a property, you should thoroughly comprehend the process of a 1031 exchange and its rules. Also, make sure to research markets and work with a trusted broker to find the right area that will fit your goals and maximize your return. 

Final Thoughts

Spotting a growing market can be difficult if you don’t know where to start. A quick Google search will show you that the Midwest is a great area to start investing in right now. Kansas City and Kansas is a growing market that’s still affordable and has lower tax rates. Kansas City offers an abundance of affordable (and available) commercial and residential properties. The property prices in Kansas City are more affordable than in other metropolitan cities, making it a desirable area. 

Property appreciation is at a high because the area is growing rapidly. And with more people moving to the area, more rental properties are needed, leaving ample room for investors to rent out properties quickly and easily. Kansas City has been ranked as one of the top 100 markets for renters. If you don’t know where to start with your out-of-state 1031 exchange, I suggest looking at the Midwest.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.