1031 Exchange: What Real Estate Investors Need To Know

For real estate investors, taxes are just part of the deal. But 1031 exchanges, named after Section 1031 of the IRS tax code, allow you to sidestep capital gains tax in some cases.

We’ve put together some tips about 1031 exchanges as well as some of the most important rules to follow.

What Is A 1031 Exchange?

How Does A 1031 Exchange Work?

You can postpone paying capital gains taxes by selling a property and putting the proceeds toward a “like-kind” property, which is a property that is similar in nature and assessed value.

If you don’t receive proceeds from the sale, there’s no income to tax. In other words, you gain no profit from the sale.

Exclusions To Section 1031

A 1031 exchange applies to real property, which primarily refers to buildings and land. There are, however, exclusions related to residency and use of the property. Section 1031 doesn’t apply to these types of exchanges:

• Primary residences
• Second homes
• Stocks, bonds or notes
• Other securities or debt
• Partnership interests
• Trust certificates

How Does A 1031 Exchange Work With Depreciable Property?

Different rules apply when you exchange a depreciable property. If you’ve claimed tax deductions for depreciation on an investment property, you may need to pay taxes on some of the profit you make when you sell. The IRS “recaptures” the taxes you would have paid if you hadn’t taken depreciation deductions.

You can take advantage of a 1031 exchange to avoid depreciation recapture on proceeds from a sale. By reinvesting the entire amount of your proceeds into the purchase of a replacement property, you can defer the tax on your capital gains.

When To Use A 1031 Exchange

There are many reasons to use a 1031 exchange. You may want to:

• Invest in a property with better ROI than your current investment property
• Consolidate several properties into one, possibly for life estate
• Reset a rental property's depreciation
• Turn your vacation home into a rental property.
• Sell your one investment property to invest in several properties

What Is An Example Of A 1031 Exchange In Real Estate?

Let’s say the value of an investor’s rental property has grown, and they want to reinvest in another property. To maximize their investment and defer capital gains tax, they can initiate a 1031 exchange. The investor uses the proceeds from the sale of the original rental property to acquire a new rental property.

Timing can be tricky when completing a 1031 exchange. The IRS requires investors to identify a replacement property within 45 days of the sale and complete the purchase within 180 days. This relatively short time frame can lead to pressure and competition, especially in high-demand markets.

To avoid issues, investors often work with real estate agents and intermediaries to help execute 1031 exchanges. The real estate agent can help find replacement properties while intermediaries can manage the exchange process and guide investors on IRS regulations.

Types Of 1031 Exchanges

You may want to look into three types of tax-deferred exchanges: delayed exchanges, reverse exchanges and build-to-suit exchanges.

Delayed Exchange

A delayed exchange is the most common exchange format. It gives investors the flexibility to purchase a replacement property within 180 days of selling a relinquished property. If the relinquished property is sold before you acquire the replacement property, the sale proceeds go to your qualified intermediary. The qualified intermediary keeps the money until you purchase the replacement property, delivering the funds to the closing agent.

Reverse Exchange

A reverse exchange is when you close on a replacement property before you close on the sale of the relinquished property. You may want to tap into this option to get a desirable replacement property in a seller’s market, especially if you encounter competing offers or need to close quickly.

When you buy the replacement property before selling the relinquished property, the property must be transferred through an exchange accommodation titleholder – i.e., the qualified intermediary.

Build-To-Suit Exchange

How To Make A 1031 Exchange

Wondering how it works when you want to make a 1031 exchange? Here’s what you can expect from the process.

1. Identify The Property You Want To Sell and Buy

The initial step is to determine which property you want to sell and which property you want to exchange. The property you’re selling and the property you’re buying must be “like-kind,” which means they’re similar, though they may not be the same quality or grade.

2. Choose A Qualified Intermediary

Next, you must work with a qualified intermediary, also known as an exchange facilitator, to handle the 1031 exchange transaction. A qualified intermediary is a person or company that sells a property on your behalf, buys the replacement asset and transfers the deed to you.

The qualified intermediary holds your sale proceeds in escrow until the exchange is complete.

What Does A Qualified Intermediary Do?

A qualified intermediary’s job is to:

• Coordinate with the seller on the structure of the 1031 exchange
• Prepare the relinquished asset and replacement property documentation
• Give instructions and appropriate documents to the escrow or title company regarding the exchange
• Create an arm’s length transaction in the agreement between the seller or exchanger and the qualified intermediary
• Deposit money from the relinquished property sale into a separate, insured account
• Hold the funds from the sale of the relinquished property during the 45-day identification period
• Hold written information about potential replacement properties
• Transfer funds once the replacement property is selected and disburse the money to the title or escrow company to purchase the replacement property
• Convey the title to the seller or exchanger by deed
• Keep complete records for the seller
• Give a 1099 form to the seller or exchanger and the IRS if needed

Choosing The Right Qualified Intermediary

It’s important to choose your qualified intermediary with care so you don’t lose money, miss key deadlines or end up paying taxes.

Confirm that the qualified intermediary you plan to work with offers:

• Real estate experience: Does the qualified intermediary have extensive real estate experience?
• Successful completion of compliance examinations: Intermediaries should meet annual compliance examinations, such as the SSAE 16.
• Transparent transactions: Can you check in on your exchange money at any time? You should always know what’s happening with your money.
• Fund security: Make sure your funds are in an FDIC-insured account.

3. Tell The IRS About Your Transaction

Lastly, you must report the exchange to the IRS by filing Form 8824 with your tax return. You’ll describe the properties involved in the exchange, provide a timeline, explain who was involved in the process and catalog all the money involved.

Both the relinquished property you sell and the replacement property you buy must meet certain requirements:

• Relinquished property: The property you want to sell is the relinquished property – sometimes known as Phase 1 or downleg – gets exchanged for a similar property in a 1031 exchange.
• Replacement property: The property you want to exchange is the replacement property – it's the “like-kind” property purchased with the proceeds from the sale of the relinquished property. This is also sometimes referred to as the upleg of the exchange.

1031 Exchange Rules, Requirements And Timeline

It’s important to ensure you fully understand the rules and regulations of a 1031 exchange, including property and time requirements.

Property Requirements

The property you exchange must meet certain requirements:

• The replacement property must be “like-kind” to the relinquished property. For two properties to qualify as “like-kind,” they must be similar enough, though most real estate can be “like-kind” to other real estate. For example, real property improved with a residential rental house is considered like-kind to empty land. It’s also important to note that properties within the United States are not like-kind to properties outside the United States.
• The exchanged properties must be similar in nature and function. For example, a rental or multifamily property can’t be exchanged for a vacation home. Remember, primary residences, second homes and vacation homes don’t qualify either.
• You can’t keep the proceeds from the sale during the exchange. All funds must be held in escrow by a qualified intermediary, or the proceeds will become taxable.

1031 Timeline Requirements

You’ll also have to adhere to certain timeline requirements when using a 1031 exchange:

• 45-day rule: You have 45 days after the sale of your relinquished property to identify replacement properties. You must identify the potential replacement property in writing. The letter must include a legal description of the property, be signed by you and shared with the seller or your qualified intermediary.
• 180-day rule: You must close on the replacement property within 180 days of closing on the relinquished property or after your tax return is due – whichever is earlier. The 180-day time limit for a 1031 tax exchange is a strict deadline. If you don’t meet it, you may be subject to capital gains tax on the profit from the sale of your property.

Tax Implications Of A 1031 Exchange

You may encounter some tax implications with a 1031 exchange, including:

• Paying taxes on “boot”: This is a term that refers to any leftover cash received in a 1031 exchange. If the investor receives “boot,” it may trigger capital gains tax on that money.
• Paying taxes on the difference in the mortgage amounts: If the replacement property has a lower mortgage amount than the relinquished property, you may get taxed on the difference because it is considered “boot” and subject to taxes.
• Paying taxes if the relinquished property isn’t sold: You’ll get taxed on the sale of the relinquished property if the sale is unsuccessful within the 180-day window.
• Deferred capital gains tax: Multiple 1031 exchanges over the years can lead to a hefty amount of deferred capital gains in the hundreds or thousands of dollars, which can increase your tax liability.

1031 Exchange FAQs

Here are the answers to some common questions regarding a 1031 exchange.

When should I not do a 1031 exchange?

The central purpose of a 1031 exchange is to reinvest your sale proceeds in a “like-kind” investment property – such as paying off debt, making a down payment, etc. If you need the cash from the sale of your investment property for any other reason, you should reconsider a 1031 exchange.

How long do I have to hold a 1031 exchange?

The IRS doesn’t mandate a fixed holding period, but the general recommendation is to hold on to a property for at least 1 year. The IRS taxes capital gains depending on how long or short you held the property. Long-term capital gains are taxed at a lower tax rate.

Which types of properties qualify for a 1031 exchange?

The Bottom Line

A 1031 exchange can help real estate investors buy more profitable properties, grow their portfolio, defer capital gains tax and continue reinvesting.

Because of its strict requirements and deadlines, a 1031 exchange can be a complicated process. It’s important to have a qualified intermediary facilitate the 1031 exchange on your behalf and ensure the transaction complies with IRS guidelines.