What is a 1031 exchange?

A 1031 exchange is a like-kind real estate swap that lets investors defer capital gains tax by rolling the proceeds from one investment or business property into another. If you meet IRS rules and keep the proceeds with a qualified intermediary, you can upgrade your portfolio without triggering a tax bill. Learn how it works, key rules, timelines, and when a 1031 can make sense.

1031 exchange rules, requirements, and timeline

1031 exchanges have rules and regulations that must be complied with before the exchange is completed. That's why it's important to fully understand the rules and regulations, including the timeline and property requirements.

Property requirements

Properties in 1031 exchanges must meet specific requirements. The replacement property needs to be like-kind to the one you're selling. Properties that are exchanged must also be similar in nature and function.

If you were to sell a multifamily home, you can’t exchange it for a vacation home or farmland. Homes in different countries don’t count either, nor do exclusions like primary residences and second homes.

Intermediary requirements

When you conduct a 1031 exchange, you can’t keep the proceeds. The funds must be held in an escrow account under the supervision of a qualified intermediary. Otherwise, your proceeds will count as taxable income.

1031 timeline requirements

You need to adhere to the timeline restrictions when conducting an exchange, either the 45-day or 180-day rule.

The 45-day rule means that you have 45 days after the sale of the property to identify the like-kind replacement property. You must identify this property in writing with a legal description of the property and your signature. This letter needs to be shared with your qualified intermediary or the property seller.

The 180-day rule requires you to close on the like-kind property within 180 days of closing on the sale of your previous property or after your tax return is due, whichever comes first.

If you don’t meet this strict deadline, you may be subject to paying capital gains tax.

Tax implications of a 1031 exchange

A 1031 exchange has different tax implications, including:

• Paying taxes on “boot:” This term refers to any leftover cash received in a 1031 exchange. Any boot an investor receives could be subject to capital gains tax.
• Paying taxes on the difference in mortgage amounts: If the property you sold has a higher mortgage amount than the like-kind one, you may get taxed on the difference, since it's considered a boot.
• Paying taxes if the relinquished property isn’t sold: Any 1031 exchange that doesn't adhere to the 180-day window rule will have to pay taxes on the relinquished property.
• Deferred capital gains tax: Multiple 1031 exchanges over time can lead to a large amount of deferred capital gains, which can increase your tax liability.

Exclusions to section 1031

There are exclusions regarding using a 1031 exchange on certain types of real property, including:

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

Types of 1031 exchanges

There are three types of tax-deferred exchanges: delayed exchanges, reverse exchanges, and build-to-suit exchanges.

Delayed exchange

A delayed exchange gives investors the flexibility to buy a replacement property within 180 days of selling a relinquished one. The sale proceeds will be held in escrow with the qualified intermediary if you sell your property before you’ve purchased the replacement one.

Reverse exchange

A reverse exchange is when you close on the purchase of the replacement property before you close on the sale of your current one.

Build-to-suit exchange

A build-to-suit exchange lets you use your tax-deferred funds to complete renovations on your new property. These improvements need to be completed within 180 days of selling your relinquished property.

When to use a 1031 exchange

Using a 1031 exchange may make sense in any of the following scenarios:

• Investing in a property with a better ROI.
• Consolidating several properties into one new one, which could be for life estate purposes.
• Turning a vacation home into a rental.
• Using the sale of one investment property to invest in several more.
• Carry over existing depreciation and potentially increase it by purchasing a higher-basis property.

How to make a 1031 exchange

Here’s what you can expect during the 1031 exchange process.

1. Identify the properties you want to sell and buy

Determine which property you wish to sell and what you want to use the proceeds for, whether that's one property or several. The property must be like-kind, meaning it's similar, though it may not be of the same quality or grade.

2. Choose a qualified intermediary

Next, you must work with a qualified intermediary, also known as an exchange facilitator. 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 will hold your sale proceeds in escrow until the exchange is complete.

3. Tell the IRS about your transaction

You will need to report the exchange by submitting Form 8824 with your tax return. In it, you'll describe the properties involved in the exchange, the transaction timeline, and the money and parties involved.

The bottom line: How a 1031 exchange is helpful

A 1031 exchange can help real estate investors leverage and grow their business by enabling them to purchase more profitable properties and defer capital gains tax. Since a 1031 exchange can be a complicated process, it's important to work with the right types of professionals to ensure you're compliant with IRS rules and regulations.

If you’re ready to take the next step, explore your financing options by starting a loan application with Rocket Mortgage.

Rocket Mortgage is a trademark of Rocket Mortgage, LLC or its affiliates.