What is a 1031 Exchange?

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One of the most important tax benefits that real estate investors should know about is a 1031 exchange — which, in simple terms, is a popular (and legal) way to bypass capital gains taxes when selling investment properties.

In this post, you’ll learn all about 1031 exchanges, including how to qualify, what the benefits are, and more.

Why Is Everyone Talking About 1031 Exchanges?

Real estate investors can save a ton of money by executing a 1031 exchange. It’s that simple.

When you sell an investment property, the goal should be to hold onto as much of your profits as possible. Your ability to reduce the amount of taxes you owe can make or break your real estate experience — and have a huge impact on your profitability.

But here’s the catch: when you profit from the sale of an investment property, you have to pay a capital gains tax to the Internal Revenue Service (IRS).

A 1031 exchange gets its name from Section 1031 of the Internal Revenue Code. Also known as a like-kind exchange, a 1031 exchange lets you avoid capital taxes when selling an investment property. However, you must invest the sale proceeds in one or more like-kind properties, in what’s called an exchange transaction (more on that later).

In addition to capital gains, you may also face a depreciation recapture fee in the event you sell a property you previously used to offset taxable income for a profit.

Suffice it to say that your tax returns get more complicated when you become a real estate investor.

Qualifying for a 1031 Exchange

Before you even think about moving forward with a 1031 exchange, make sure your transaction qualifies. Not all sales are eligible, and the last thing you want is to owe tons of money in capital gains taxes when you initially thought the deal would be tax-free.

Real property can qualify for a 1031 exchange if it’s held for investment, trade, or productive use.

This is very important: Section 1031 does not apply when flipping houses. It’s only for investment properties — not for properties you immediately resell.

Here are some additional requirements to keep in mind:

Investment Type Must Match

The relinquished and replacement property both have to be for investment purposes. In other words, you can’t take a business property and a personal property like your primary residence, exchange properties, and avoid paying capital gains taxes. It has to be a like-kind exchange.

That said, the properties’ use types don’t have to be exactly the same. For example, you might be able to exchange a commercial building for a residential apartment complex (if you aren’t living there).

The main takeaway here is that the exchanged properties must be investments and not for personal use.

Time Limitations

Once a property is closed, you have a time limit of 45 days to identify up to three properties that you want to acquire. If by the end of the 45-day period the properties are not identified, the proceeds from the sale will be returned and the capital gains tax will be nullified. As such, it is critical to have the details associated with the purchase of the replacement property arranged in advance.

In a 1031 exchange, investors must also follow the 180-day rule. This rule mandates that the total transaction gets completed in six months or no more than 180 days after the closing. If you go beyond the 180-day mark, the exchange will be canceled, and you owe capital gains.

Exchange Facilitators Required

An exchange facilitator — which can also be called an intermediary, qualified intermediary, or accommodator — is a person that facilitates the exchange of like-kind property.

According to IRS Tax Code (IRC), you must hire a facilitator to conduct a 1031 exchange. In basic terms, this person serves as an impartial intermediary to the transaction. Here’s how it works:

First, the facilitator buys the property from you and charges a fee. Next, they transfer your property over to the buyer, and deposit your profits into an escrow account.

The facilitator then acquires the property that you wish to exchange for your relinquished property. Finally, the intermediary transfers the acquired asset over to you, and you officially become the property owner.

As you can see, a 1031 exchange is not as simple as “exchanging” investment properties!

Two Types of 1031 Exchanges to Know About

Here’s another wrinkle to throw in the mix: If this didn’t sound complicated enough, there are two different kinds of 1031 exchange processes to be aware of.

1. Delayed 1031 Exchange

In a delayed 1031 exchange, an exchanger gives up — or relinquishes — property before acquiring another one. Then the new property is acquired in another transaction. It’s important to note that the exchanger must find a buyer and complete a sale before the delayed exchange takes place.

2. Reverse Exchange

In a reverse exchange, an exchanger acquires a replacement property first. Then the current property is swapped. This enables a buyer to obtain property before having to sell their investment. It’s a way to execute a transaction and then buy extra time until market value increases, guaranteeing the best possible return value on a home.

Benefits of a Tax-Deferred Exchange

Here are some of the main reasons you may want to consider completing a like-kind tax-deferral.

Defer Tax Liability

Real estate investors tend to like 1031 exchanges because of the long-term tax benefits. In a 1031 exchange, the tax deferment lasts until you die. It does not expire while you are still alive and in command of the property.

If your heirs receive an inherited property through a 1031, the price of the property increases to fair market value. This, in turn, cancels out the debt from the deferent. That said, if you are planning to pass along any property after your death, it’s worth working with an advisor to walk the family through the transition.

As for how much money you can save, that comes down to your capital gains tax rate.

To figure out your approximate capital gains, take the sales price of your property, and subtract what you paid for it, along with any closing costs and non-declarative investments that you put into the property. For example, a non-declarative investment could be a new staircase or a swimming pool.

The IRS is going to tax your capital gains at a rate of 0%, 15%, or 20% depending on your taxable income — or at a depreciation recapture tax rate not to exceed 25%.

Let’s say your old property sells for $1.2 million, and your profit after closing costs and non-declarative investments is roughly $200,000. You could be looking at owing from $30,000 to $50,000 in taxes (without utilizing a 1031 exchange).

Improve Your Real Estate Position

Participating in a 1031 exchange agreement can also help you gain a market advantage. Instead of paying taxes on the sale of a property, you can instead put that money toward the down payment on a new property, and potentially one that’s even more valuable, and a better deal than your previous property.

As such, investors often use the 1031 exchange as a stepping stone to acquire more real estate. Mastering the 1031 rule is a way to gain a stronger foothold in the market, and most importantly, to increase your net worth.

Improve Your Cash Flow

A 1031 exchange can lead to a steady cash flow and residual income from your new property. But how?

By exchanging vacant land for a rental property, for example, you can walk right into an income-generating investment. (But make sure to have a qualified expert help you conduct this transaction).

Diversify Your Portfolio

Yet another benefit to a 1031 exchange is that it’s flexible. For example, you may choose to sell a large house for a portfolio of rental properties in another market. By taking this approach, you can spread your investment around, reduce your risk, and potentially make more money.

It’s also an avenue for hedging against depreciation.

Suppose you own a rental property for more than 27.5 years. At that point, it is no longer eligible for an annual depreciation deduction. At the same time, the net rental income may only be a small percentage of the building’s total equity — meaning it could make more sense to exchange the building for one or more properties that can produce stronger returns.

Tips for a Seamless 1031 Exchange

Pulling off a 1031 exchange is not impossible. Plenty of real estate investors complete 1031 exchanges, making it a tried and true method of making money. However, it’s not always a walk in the park.

Here are some things to keep in mind before exploring this type of transaction.

Keep Track of Deadlines

As you probably are already aware, successful real estate investing often involves managing time frames and constantly keeping an eye on the calendar. This is especially true when doing a 1031 exchange.

Remember, you only have 180 days from the time of the sale to close a replacement property. Otherwise, you’re going to owe capital gains.

What’s more, if Tax Day falls in between the 180-day period, you will have to close by the time you settle up with the IRS. In most cases, this falls on April 15.

While 180 days may seem like an eternity when you close a deal, it can sneak up on you quickly. Best practices call for having potential replacement properties ready to go before you execute a 1031 arrangement to avoid any potential lapses.

Make Sure You Buy Enough Replacement Real Estate

To defer all of your taxes, your replacement property must be of equal or greater value to the property you are selling.

As an example, let’s say you sell a 4-unit condo complex that’s valued at $750,000. The property you buy has to be at least $750,000 or more in value. Otherwise, you will have to pay a capital gains tax on your profits.

In addition, you have to invest all of your profits from the sale into the purchase of your next property. So, if you initially paid $650,000 for your 4-unit condo, and you sell it for $750,000, you can’t pocket the $100,000 profit. Instead, the profit must be applied toward your next property.

Find a Top Real Estate Agent​

The key to getting ahead in real estate is to have a strong team of advisors by your side. Having a qualified real estate agent walk you through each step of a 1031 exchange is essential (unless you’re a real estate expert yourself).

Not only can your real estate agent help you find the best deals, but they can also hold you accountable to the tremendously important 1031 exchange deadlines.

TIP: Work with an agent that you know and trust. If you don’t have a trusted real estate agent, don’t just hire the first person you come across.

Hiring a real estate agent like hiring an employee. Be prepared to ask questions and make sure they are on top of their game.

Hire an Experienced Attorney

It should be obvious by now that a 1031 exchange is essentially a complex tax loophole. As with any complicated tax matter, be sure to hire a competent attorney and tax advisor who will be in your corner. There is a ton of paperwork that needs to be filed, that very few people are able to manage on their own.

The right attorneys and tax experts should also have many years of experience doing these types of deals. Therefore, they already know what to look out for, and how to efficiently go about the process.

Frequently Asked Questions

What is the 200% rule?

The 200% rule is yet another rule to be aware of during a 1031 exchange.

Under the 200% rule, you can identify an unlimited number of replacement properties if the total value does not exceed 200% of the fair market value of what your relinquished property sells for.

However, if you keep your list of identified properties to three or less, the 200% rule does not apply. Best practices seem to suggest keeping your list to three properties or less, so the 200% rule probably doesn’t apply to most investors. Nonetheless, the 200% rule is something to watch out for.

What is depreciation recapture?

Depreciation recapture refers to a gain from the sale of depreciable capital property, and it’s subject to income tax by the IRS.

This occurs when the sale price of an asset is more than the adjusted cost basis or tax basis. In short, the IRS can use it to collect taxes on a profitable sale on an asset that was used to offset taxable income.

On a piece of real estate property, depreciation recapture is capped at 25%.

Does vacant land qualify for a 1031 exchange?

Yes. Vacant land qualifies for a 1031 exchange. As discussed above, you can potentially exchange vacant land for a lot with an apartment building on it and potentially enjoy immediate gains in the form of rent. However, the land has to match the value of the property you are buying to qualify.

Does a vacation home qualify for a 1031 exchange?

A vacation home can qualify for a 1031 exchange as long as the home meets the IRS’s stringent requirements for an exchange. It’s important that the house is an investment property.

This is where it pays to have a savvy real estate agent as a partner. Your real estate agent will be able to quickly verify whether or not you are in line with 1031 regulations.

What is fair market value?

Fair market value or FMV is a price that real property would sell for under standard market conditions. Fair market value can be determined based on the updated cost or selling price, replacement cost, or by an independent appraisal.

The Bottom Line

If you’re selling a lucrative real estate investment, a 1031 exchange can be your best friend. The process can help diversify and increase the value of your real estate holdings while sheltering your proceeds from capital gains tax. And let’s be honest: Who wants to pay more than they owe?

Just remember that a 1031 exchange requires expert oversight from several trusted advisors. Also, keep in mind that you can only qualify under certain conditions, and you have to be very careful about IRS deadlines, and tax codes.

As the saying goes, nothing good comes easy.

Assuming you qualify for a 1031 exchange and it makes sense for your unique situation, you’d be foolish not to use it. Good luck in your real estate investing endeavors!

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