There are numerous tax advantages associated with real estate investing, but perhaps none is more misunderstood than the 1031 exchange. The ability to shelter taxes is invaluable, which begs the question: What is a 1031 exchange? Simply put, it is a tax designation that has become synonymous with some of the greatest benefits of real estate investing. When executed correctly, a 1031 exchange can save investors an incredible amount in taxes and grow their portfolios in the process.
Unfortunately, far too many investors are unaware of the 1031 exchange and how to use this strategy correctly. If you are thinking of selling your passive income property (or you want to grow your real estate investing business), familiarize yourself with the concept of a 1031 exchange. This strategy may be the one thing you need to take your career to the next level.
What Is A 1031 Exchange?
A 1031 exchange is when you sell an investment property and purchase another within a designated period — essentially swapping the two properties. This strategy is laid out by the Internal Revenue Service (IRS) as Section 1031 can defer capital gains taxes. A 1031 exchange generally must apply to business or investment properties, though there are a few rare exceptions for vacation homes and primary residences. There is no limit to how frequently or how many times an investor can use a 1031 exchange. For example, investors could use a 1031 exchange each time they buy and sell a passive income property. In doing so, the investor could build a tax-deferred investment portfolio.
However, it is worth noting that the tax postponement laid out by a 1031 exchange will only be granted if certain criteria are met, namely, if the proceeds from the sale are reinvested into a “similar” property. Or as the IRS puts it, “Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and 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.” In other words, a 1031 exchange offers investors the ability to offset the capital gains tax — provided the new property meets the criteria set forth by the IRS.
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Who Can Take Advantage Of A 1031 Exchange?
To qualify and partake in a 1031 exchange, you must be an investment or business property owner. More specifically, “Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts, and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031,” according to the IRS.
Besides being the owner of an investment or business property, there are other details to consider. For starters, not every investment property qualifies as a viable 1031 exchange candidate. To qualify, the investment property must have been held to generate passive income, such as a typical rental property. Rehabs, on the other hand, do not qualify. This is because, by definition, rehab properties are held for capital gain and not passive income. Moreover, each property in a 1031 exchange must be owned by the same person. That means an investor cannot sell a rental property under their name and buy a similar property under their limited liability company (LLC).
I want to make it abundantly clear; the property must have been used as an investment to earn passive income. That means property used for personal use, like your primary home, will typically not qualify under the standards of a 1031 exchange. To better understand what qualifies a transaction to partake in a 1031 exchange, consult the rules and regulations laid out by the IRS in the Internal Revenue Code. The information contained in this article is in no way intended to be used as tax advice and is, therefore, a brief overview of what to expect.
How Does A 1031 Exchange Work?
Investors who have taken advantage of a 1031 exchange are well aware of how beneficial the ability to defer taxes to a later date can be. Postponing capital gains is an incredible tax sheltering tool, which begs the question: How does a 1031 exchange work? The answer can be broken down into five simple steps:
Choose A Subject Property To Sell: Identify the property which is to be sold for a capital gain.
Choose A Subject Property To Buy: Identify a subject property to buy with the proceeds from the sale of the first home.
Make Sure Each Property Is “Like-Kind”: The properties being bought and sold must be like-kind. For two properties to be of like-kind, they must be similar in nature and character. The quality or grade of the subject properties isn’t relevant; only that they are objectively similar types of physical real estate.
Execute The Transaction With A Qualified Intermediary: In the event each subject property qualifies as like-kind, investors must execute the transaction with a qualified intermediary. Otherwise known as exchange facilitators, the proper intermediaries will carry out the transaction with their own escrow account to keep everything in order.
Inform The IRS Of The Transaction: When it comes time to file taxes, fill out IRS Form 8824 to inform the IRS of the transaction. When filling out the form, describe the subject properties, identify the dates, explain who was involved, and keep records of the flow of money.
1031 Exchange Rules
While a 1031 exchange sounds simple by nature, it is much more complex than many investors think. In its simplest form, a 1031 exchange sees two investors quite literally exchanging ownership of their investment properties — though it rarely happens this way. In reality, there are often delayed exchanges, intermediaries, and even timing restraints. Policy changes can further complicate these rules, making the process stricter and, in some cases, harder to navigate. For example, the Tax Cuts and Jobs Act (TCJA) in 2017 prohibited using 1031 exchanges to buy and sell personal property (such as aircraft, franchise licenses, and other investments). It is crucial to understand each of the regulations surrounding a 1031 exchange before attempting this strategy. Review the 1031 exchange rules listed below to help avoid any confusion:
Like-Kind Property: To qualify for a 1031 exchange, the property you buy after selling your original property must be similar or like-kind. According to the IRS, like-kind suggests the two properties are “the same nature or character, even if they differ in grade or quality.”
Investment Or Business Property: The property you sell for a 1031 exchange must have been used for business or investment purposes. That means a primary residence is not eligible.
Greater Or Equal Value: The value of the property you intend to purchase in the exchange must be greater or equal in value to the property you sold if you want to defer 100 percent of the capital gains tax.
Beware The “Boot”: If the new property is less valuable than the original, you can carry out a partial 1031 exchange, but the exchange won’t be 100% tax-free. The difference in value, otherwise known as the “boot,” will represent the amount the buyer will pay capital gains on.
Same Owner: The same person must own each property involved in the exchange. That means an investor can’t sell a rental property under their name and by a similar property under their LLC.
45-Day Rule: The seller has 45 days to identify a new property they intend to conduct the exchange with. In addition, they must notify the proper authorities.
180-Day Rule: The replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property. Before the due date of the income tax return for the same tax year, the original property (the first property in the exchange) was sold, whichever comes first.
1031 Exchange Tax Implications
It is important to pay attention to any leftover money you have after completing the 1031 exchange. Let’s say you sold your first property for slightly more than the value of the second. The extra cash from the sale (referred to as “boot”) would still be classified as a gain and would therefore be taxed accordingly. The same would apply to outstanding loan amounts — for example, if the mortgage on your new property were $75,000 less than the mortgage on the property you sold. In this case, you would still be taxed on the $75,000 difference. It is crucial to pay attention to these differences when attempting a 1031 exchange, as these tax implications may undermine what you are trying to accomplish.
1031 Exchange Timeline
Each transaction associated with the exchange must occur within a certain amount of time to qualify for a 1031 exchange and postpone taxable gains. That’s not to say the exchange needs to happen simultaneously, but rather that the IRS has put a limit on the amount of time that may pass from when you sell your first investment property to when you buy the second one. Perhaps even more importantly, investors will be held to two specific time limits, neither of which may be extended.
The first time limit investors need to pay special considerations to is the amount of time they have to identify a replacement. According to the IRS, investors must identify a replacement property within 45 days of relinquishing control of their first property. That said, identifying a replacement candidate is a little more involved than simply finding a home; you will need to submit something in writing declaring your interest. The identification must be in writing, signed by both the individual interested in the 1031 exchange and the replacement property seller. In addition to a signature, the written document must include a “legal description, street address, or distinguishable name.” You can’t simply give notice to your attorney, real estate agent, accountant, or anyone else representing your side of a deal.
Provided the investor has identified a suitable replacement within 45 days, there’s only one more time limit to abide by: the amount of time it will take to close on the subsequent property. The next property must be “received, and the exchange completed” within 180 days of the first home’s sale, “or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier,” according to the IRS.
1031 Exchange Calculator
The only way to accurately calculate the costs associated with a 1031 exchange is to employ a well-versed tax representative in Section 1031 guidelines. The process is complicated, as gains are merely deferred and not forgiven. As a result, always hire a professional before calculating a 1031 exchange. That being said, it can be helpful to understand the information required. The basic tenets for calculating the basis of a 1031 exchange are as follows:
Look at the adjusted basis of the property you sold, including any mortgage or loan amounts. (Basis refers to the cost of the property for tax purposes)
Add in the new property value, mortgage amount, down payment and recognized gain from the property you sold
Then, subtract the money you received in the exchange, the mortgage on the sold property, and any loss recognized in the exchange
The variables listed above will not apply in every 1031 exchange, but it can still help understand where they come into play. By working with a professional and walking through the steps listed above, you can calculate the basis of a 1031 exchange.
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Types Of 1031 Exchanges
It is important to note that not all 1031 exchanges are created equal; there are, in fact, different types of 1031 exchanges. If for nothing else, real estate transactions are a complicated matter. The complex nature of the real estate market has brought about the need for at least four types of 1031 exchanges:
Reverse 1031 Exchanges
Delayed exchanges, as their names suggest, grant investors the luxury of more time. Specifically, investors are given up to 180 days after they sell their original (relinquished) home to close on the new (replacement) home. Since the original property is usually sold before a new one can be purchased in a delayed exchange, the proceeds from the relinquished property will be transferred to an escrow held by a qualified intermediary. The money will remain with the intermediary until a replacement property is identified and purchased; at that time, the money will be transferred from the holding account to the respective closing agent.
As I already alluded to, qualifying investment or business property owners must reinvest the original sale proceeds into a similar property to qualify for a 1031 exchange. Having said that, “like-kind” and “similar” have become synonymous with one another, at least as they are referenced in Section 1031. In other words, a 1031 like-kind exchange refers to when an investor sells a rental property and uses the proceeds to buy a similar property, which begs the question: What exactly is a like-kind property? How similar (or different) can properties be to qualify for such an exchange?
According to the IRS, like-kind properties are just that: of like-kind. Properties qualify for a 1031 like-kind exchange “if they are of the same nature or character, even if they differ in grade or quality.”
Under the rules specified by Section 1031, most properties will be like-kind to other properties. Of course, there are exceptions. Property in the United States, for example, is not considered like-kind to property in other countries. For more information on what’s considered like-kind (and what’s not), please consult a tax professional. Only tax professionals well-versed in Section 1031 of the Internal Revenue Code will be able to confirm whether or not two properties are officially of like-kind.
Reverse 1031 Exchange
Otherwise known as a forward exchange, a reverse 1031 exchange is “when you acquire a replacement property through an exchange accommodation titleholder before you identify the replacement property,” according to RealWealth Network. In other words, a reverse 1031 exchange is exactly what its name suggests: the investor will buy first and pay later.
Otherwise referred to as a construction exchange, a built-to-suit exchange allows investors to use the deferred proceeds from the relinquished property to fund renovations on the replacement property. It is important to note, however, that any improvements being made to the new property must be completed within the 180 day timeframe in order to claim the deferred tax dollars on the appropriate tax filing date.
1031 Exchange Examples
The ambiguous nature of a like-kind property has continued to confuse investors for quite some time. To help clear things up, here are a few 1031 exchange examples:
It is possible to exchange an apartment building for a duplex.
It is possible to exchange a single-family rental that has produced passive income for a commercial building.
It is possible to exchange a rental property for another rental property.
To be clear, most properties will be like-kind to other properties — with a few exceptions, of course.
1031 For Vacation Properties
The use of a 1031 exchange to buy or sell a vacation property has become somewhat of a real estate urban legend. Many investors have heard of someone doing it but have often not tried it for themselves. This is because policy changes have continued to tighten which properties are eligible for a 1031 exchange. While this designation may have previously contained loopholes, it has become exceedingly rare to see someone use a 1031 exchange to acquire a vacation property.
A 1031 exchange states that eligible properties must be used for business or passive income, therefore eliminating most people’s second homes. In theory, you could convert a vacation home to a rental by finding tenants for most of a year, if not longer. At this point, the home might be considered a passive income property and would then be eligible for a 1031 exchange. However, keep in mind that these rules are stringent, and you should always double-check with a tax professional before attempting to change the status of a residential property.
1031 Swap Residence
If you intend to purchase a property under a 1031 exchange to make it your primary residence, there are a few things you should know. In 2008, the IRS added a safe harbor rule stating that it “will not challenge whether a dwelling unit qualifies as a property held for productive use in a trade or business or investment purposes.” The rule outlines the following requirements for a 1031 exchange:
Your personal use of the property cannot exceed 14 days or 10 percent of days in the 12-month period the property is deemed as a rental.
The property must be rented out to another person for more than 14 years of the 12-month period after the exchange.
Before the safe harbor rule was enacted, investors could purchase a property and rent it out for a designated period before moving in. At that point, they could sell the property as a primary residence and take advantage of the exclusion of gain tax code (which allows eligible homeowners to exclude up to $250,000 from a home sale on their reported income). Now, there are stricter rules to prevent investors from working around the rules of a 1031 exchange.
How To Do A 1031 Exchange In 8 Steps
Now that you understand the basics of a 1031 exchange, it can help review the process. The following steps should walk you through a 1031 exchange and give you a better idea of how to implement this real estate strategy:
Consider The Benefits Of A 1031 Exchange: While a 1031 exchange can represent an exciting opportunity to grow your real estate portfolio, it may not always be the best move. Consider the eligibility requirements of a 1031 exchange and compare them to your goals of selling a passive income property. It is also helpful to consider the market status, property ownership structure, and financial needs.
Hire A Professional: As I have mentioned, the timeline and requirements associated with a 1031 exchange are both highly regulated and strictly enforced. If you want to pursue a 1031 exchange, it is best to call in professionals to help you create an achievable plan for the exchange. Several real estate companies supervise 1031 exchanges and can help with the process.
Alert Your Real Estate Team: Notify your real estate attorney and tax advisor before you make any changes to your portfolio. They will help you with any additional questions and guidance you may need to complete the process. If you typically work with a financial advisor or CPA, let them know as well.
Enter A Contract To Sell Your Property: Find a real estate broker or agent to work with when you are ready to list and market your passive income property. They will represent the sale and provide you with information on the timeline you are working in.
Choose A Qualified Intermediary: The role of an intermediary is to help open the exchange, hold the profits made from the sale of your property, and ultimately release the funds into your replacement property. The IRS requires an intermediary to ensure the process is completed within the designated guidelines.
Find Your Replacement Property: Work within the allotted timeline to find a replacement property for your portfolio. Remember to follow the 45-day rule, stating that your new property must be found within 45 days of closing on the property you sold.
Close The Sale: Now, the 180-day rule comes into place stating that you must close on the replacement property within 180 days of selling your first property. The company you chose to work with throughout the exchange will help throughout the closing process to ensure the exchange is completed.
Notify Your Tax Professional: After closing the sale of your replacement property, notify your tax advisor of the completed exchange. They will then prepare the property tax forms and finalize the process before your annual taxes are due.
What is a 1031 exchange? The question is simple, but the answer may be the solution investors are looking for to shelter their own taxes between investment properties. This strategy is one of the best ways to offset capital gains taxes in real estate, though it is often misunderstood because of its strict regulations and policy changes.
Completing a successful 1031 exchange can be highly beneficial to your real estate investment portfolio. Remember that while the process is complex, you can execute it correctly with the help of qualified professionals. Consider the various advantages of a 1031 exchange before selling your next investment property; you never know how it might help your real estate business.
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