1031 Exchange: What Real Estate Investors Need To Know
February 15, 2024 8-minute read
Author: Melissa Brock
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?
A 1031 exchange is a real estate investing tool that allows investors to exchange an investment property for another property of equal or higher value and defer paying capital gains tax on the profit they make from the sale.
This method is popular with investors looking to upgrade properties without paying taxes on proceeds.
A 1031 exchange – also known as a “like-kind” or Starker exchange – applies to real property, which primarily refers to buildings and land.
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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 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.
What Is An Example Of A 1031 Exchange?
Investors can grow their real estate investment portfolios faster by taking advantage of a 1031 exchange. Instead of paying taxes on their proceeds, they keep all their money and reinvest it into a new property.
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.
How To Make A 1031 Exchange
Now that you know how a 1031 exchange works, let’s go over an example of a 1031 exchange.
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. The qualified intermediary holds your sale proceeds in escrow until the exchange is complete.
Choose your qualified intermediary with care so you don’t lose money, miss key deadlines or end up paying taxes.
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.
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.
The property you want to exchange is the replacement property is 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.
What Is A Qualified Intermediary?
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.
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 the right qualified intermediary. Confirm that the qualified intermediary you’re considering 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.
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. For example, you’d stop using your beach house, rent it out for a few months, then exchange it for another rental property.
- Sell your one investment property to invest in several properties. You can buy three investment properties if you choose – there’s no limit. To purchase more than three investment properties, your qualified intermediary will need to walk you through the rules for financing multiple rental properties.
1031 Exchange Requirements And Timeline
Let’s discuss the rules and regulations of a 1031 exchange, including property and time requirements.
The property you exchange must meet certain requirements:
- The replacement property must be “like-kind” to the relinquished property or of equal or greater value. For two properties to qualify as “like-kind,” they must be similar enough. 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. 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.
Finally, Section 1031 doesn’t apply to these types of exchanges:
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Trust certificates
1031 Timeline Requirements
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.
- 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.
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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.
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.
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 – the qualified intermediary.
A build-to-suit exchange, also known as a construction exchange or improvement exchange, allows investors to use the deferred tax dollars from the sale of their investment property toward renovations on the replacement property. The improvements must be completed within 180 days.
Tax Implications Of A 1031 Exchange
You may encounter some tax implications with a 1031 exchange, including:
- Paying taxes on “boot,” which 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.
- 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.
- You’ll get taxed on the sale of the relinquished property if the sale is unsuccessful.
- 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.
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1031 Exchange FAQs
Let’s address some common questions to help explain when and how to take advantage of a 1031 exchange.
What is 1031 exchange depreciation recapture?
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. Take advantage of a 1031 exchange to avoid depreciation recapture on proceeds from a sale. Defer taxes by reinvesting the entire amount of your proceeds into the purchase of a replacement property.
When should I not do a 1031 exchange?
If you need the cash from the sale of an investment property for anything other than the central purpose of a 1031 exchange, which is to reinvest your sale proceeds in a “like-kind” investment property – such as paying off debt, making a down payment, etc. – 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?
Rental properties, commercial buildings and vacant land qualify for a 1031 exchange. Primary residences and second homes aren’t eligible for 1031 exchanges.
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.
Investing in real estate takes time and thorough research to navigate its ins and outs. Take the next step on your real estate investment journey and start the mortgage application process with Rocket Mortgage®.
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