1031 Exchange: What Real Estate Investors Need To Know
Melissa Brock7-minute read
December 23, 2020
As a real estate investor, taxes are just part of the deal. However, 1031 exchanges, which are named for the IRS Section 1031 of the IRS’s tax code, allow you to sidestep capital gains.
We’ve put together some tips about 1031 exchanges as well as some of the most important related rules you must follow.
What Is A 1031 Exchange?
A 1031 exchange is a real estate investing tool that allows investors to swap out an investment property for another and defer capital gains or losses or capital gains tax that you otherwise would have to pay at the time of sale. This method is popular with investors looking to upgrade properties without being charged taxes for the proceeds.
You’ll also hear 1031 exchanges referred to as a like-kind exchange or a Starker exchange. Section 1031 applies to property beyond real estate, but many 1031 cases also deal with buildings and land.
How Does A 1031 Exchange Work?
As a seller, you can postpone capital gains taxes by selling a property and putting the proceeds toward a like-kind property, or property similar in nature and value.
If you don’t receive any proceeds from the sale, there’s no income to tax. In other words, you gain no profit from the sale. That’s the idea behind a 1031 exchange, and here’s how to make that work:
Step 1: Identify The Property You Want To Buy And Sell.
The property you’re selling and the property you’re buying must be "like-kind," which means they must be similar but not necessarily the same quality or grade.
Step 2: Choose A Qualified Intermediary.
You must work with a qualified intermediary, also known as an exchange facilitator, on a 1031 exchange. The qualified intermediary holds your funds in escrow for you until the exchange is complete. Choose the right qualified intermediary so you don’t lose money, miss key deadlines or end up paying taxes now instead of later.
Step 3: Tell The IRS About Your Transaction.
Lastly, you’ll need to tell the IRS about your transaction through IRS Form 8824 with your tax return. On that form, you’ll describe the properties, provide a timeline, explain who was involved in the process and list the money involved.
Both the relinquished property you sell and the replacement property you buy must meet certain requirements.
The relinquished property is being exchanged for another in a 1031 exchange. It’s also known as Phase 1 or Downleg.
A replacement property refers to the like-kind parcel being bought with the proceeds from the relinquished property.
What Is A Qualified Intermediary?
A qualified intermediary is a person or company that sells your property on your behalf, buys the replacement asset, then transfers the deed to you. The qualified intermediary is responsible for holding the proceeds from the 1031 exchange real estate transaction so that the sale is not taxable, handling the transition of funds from the investor exchanging like-kind properties and the seller of the replacement property, preparing the legal documents and ensuring that the transaction is completed within IRS guidelines.
Let’s dig into a qualified intermediary’s job responsibilities a little further. They will:
- Coordinate with you, the seller, on the structure of the 1031 exchange.
- Prepare the relinquished asset documentation and the replacement property documentation.
- Give instructions and the appropriate documents to the escrow or title company about the exchange.
- Create an arm’s length transaction in the agreement between the seller or exchanger and the qualified intermediary.
- Transfers to the qualified intermediary, who works to convey the asset to the buyer.
- Handles money from the relinquished property sale and deposits these funds into a separate and insured account.
- Holds the funds from the sale of the relinquished property during a 45-day identification period.
- Holds written information about potential replacement properties.
- Transfers funds once the replacement property has been selected and disburses them to the title or escrow company for the purchase of the replacement property.
- Conveys the title to the seller or exchanger by deed.
- Keeps complete records for the seller.
- Gives a 1099 to the seller or exchanger and the IRS if needed, for interest.
It’s important to choose the right qualified intermediary for you. Confirm that the qualified intermediary you’re considering offers:
- Real estate experience. Does the qualified intermediary have extensive real estate experience?
- Successfully completed compliance examinations. Processes should meet annual compliance examinations, such as SSAE 16.
- Transparency in transactions. Can you view your exchange money at all times? You want to know what’s happening with your money at all times.
- Fund security. Make sure your funds are held in an FDIC-insured account for safety.
When To Use A 1031 Exchange
There are multiple reasons why you might want to use a 1031 exchange. You may want to:
- Invest in a property with better return prospects than your current investment property.
- Consolidate several properties into one, possibly for life estate planning purposes.
- Reset the property’s depreciation.
- Turn your vacation home into a rental property and do a 1031 exchange. (Here’s an example of how that can work: You stop using your beach house, rent it out for a few months, then exchange it for another property.)
- Sell your investment property and invest in more than one property. For example, you can buy three investing properties if you want to – there’s no limit. However, if you buy more than three, your qualified intermediary will have to go over some extra rules with you.
1031 Exchange Rules And Requirements
Here, we list the rules and regulations that pertain to a 1031 exchange, including property requirements and time requirements.
The property you exchange must abide by certain requirements:
- The replacement property must be like-kind, or of equal or greater value to the relinquished property. Both properties must be similar enough to qualify as "like-kind." 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. Note that property within the United States is not like-kind to property outside of the United States.
- The exchanged properties must be similar in nature and function. For example, a rental or multifamily property cannot be exchanged to acquire a vacation home. Personal use residences, such as a primary residence, second home or vacation home, do not qualify as like-kind exchanges. Actual property and personal property (which can include machinery, equipment, collectibles, vehicles, boats, aircraft, artwork, patents and other intellectual property) can both qualify as exchange properties under Section 1031 but actual property can never be like-kind to personal property. The rules are more restrictive for personal property as well. For example, cars are not like-kind to trucks.
- You cannot hold the money made from a sale during the exchange at any time. All funds must be held in escrow by a qualified intermediary or the proceeds will become taxable.
Finally, Section 1031 does not apply to these types of exchanges:
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Trust certificates
You must also adhere to specific timelines with a 1031 tax exchange or the gain on the sale of your property may become taxable:
- You have 45 days after the sale of your relinquished property to find potential replacement properties. You must do so in writing and share it with the seller or your qualified intermediary.
- 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.
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. Consider the following:
A delayed exchange is the most common exchange format because it offers you flexibility of up to a maximum of 180 days to purchase a replacement property. If the relinquished property is sold before you acquire the replacement property, the sale proceeds go to your qualified intermediary. The qualified intermediary holds the money until you acquire the replacement property and your qualified intermediary will deliver funds to the closing agent.
A reverse exchange, or forward exchange, involves closing on the purchase of the 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 when it’s a seller’s market, especially if you encounter competing offers or a pressing need to close quickly.
When a replacement property is purchased before the sale of the relinquished property, again, the property must be transferred through an exchange accommodation titleholder – the qualified intermediary.
A built-to-suit exchange, also known as a construction exchange or improvement exchange, is an exchange that allows the deferred tax dollars to be used towards renovations of the replacement property. The improvements must be completed within the 180-day period.
Tax Implications Of A 1031 Exchange
You may encounter some tax implications as a result of doing a 1031 exchange. Consider the following:
- Capital gains may occur for leftover cash, known as the “boot,” following an exchange.
- If the mortgage on the replacement property is lower than the one of the relinquished property, you may get taxed on the difference.
- You’ll get taxed for the sale of the relinquished property if the sale is unsuccessful.
- If you enact many 1031 exchanges over the years, these can yield deferred gains numbering in the hundreds or thousands, increasing your tax liability.
The Bottom Line
Normally, you can roll over your investments into new properties indefinitely, but as soon as your investment is rolled over into a different asset (such as sold for cash) you’re on the hook for the capital gains tax once the final asset is sold.
It’s possible to avoid this process and defer your capital gains taxes. You may be able to use a 1031 exchange as long as the proceeds from the sale and the principal investment are reinvested into a new property within 180 days.
1031 exchanges pose some restrictions on the type of property that qualifies for a 1031 exchange. 1031 Exchanges require that the replacement investment be of “like-kind” to the investment being sold. As long as the property is being used for commercial or investment purposes, it qualifies as “like-kind.”
You’ll need a qualified intermediary to facilitate the 1031 exchange on your behalf. A qualified intermediary is a person or company who sells your property on your behalf, buys the replacement asset, holds the proceeds from the real estate transaction so that the sale is not taxable, handles the transition of funds, prepares the legal documents and ensures that the transaction is completed with IRS guidelines in mind.
You can look into delayed exchanges, reverse exchanges and build-to-suit exchanges as well. Read more real estate tips at the Rocket Mortgage® Learning Center.
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