For real estate investors, taxes are an inevitable part of the game. However, a 1031 exchange named after Section 1031 of the IRS tax code can help you defer capital gains taxes under certain conditions.
The term "1031 exchange" is widely used among real estate agents, title companies, and investors and has even become a verb in the industry, as in, “We should 1031 that property for another.”
If you're thinking about a 1031 exchange or just curious about how it works, here’s what you need to know about the rules.
What Is Section 1031?
A 1031 exchange, also known as a like-kind exchange or Starker exchange, involves swapping one investment property for another. Typically, such transactions are taxable as sales, but if your exchange meets the 1031 requirements, you can defer taxes or avoid them entirely during the exchange.
In essence, according to the IRS, you can change the nature of your investment without cashing out or recognizing a capital gain. This allows your investment to continue growing tax-deferred. There's no limit to how often you can execute a 1031 exchange. You can roll over the gains from one investment property to another and another indefinitely.
Even if you profit on each swap, you won’t owe taxes until you sell for cash years down the line. If done correctly, you’ll only pay taxes at the long-term capital gains rate (which, as of 2024, ranges from 0% to 20%, depending on your income).
To qualify, most exchanges must be of "like-kind," a term that’s more flexible than it sounds. For instance, you can swap an apartment building for raw land or trade a ranch for a strip mall. The rules are surprisingly broad. You can even exchange one business for another. However, there are pitfalls to watch out for.
The 1031 provision applies to investment and business property, though under certain conditions, it can also apply to a former primary residence. There are also specific ways to use a 1031 exchange for vacation homes, though the opportunities are more limited than they once were.
When to Use a 1031 Exchange
There are several scenarios where a 1031 exchange might be beneficial. You might want to:
- Invest in a property with a better return on investment (ROI) than your current one
- Consolidate multiple properties into one, perhaps for estate planning purposes
- Reset the depreciation on a rental property
- Convert a vacation home into a rental property
- Sell one investment property to purchase several others
If you're considering buying multiple properties, note that you can acquire up to three properties in a 1031 exchange. To purchase more than three, you’ll need to work closely with a qualified intermediary who can guide you through the rules for financing multiple rental properties.
What Is An Example of a 1031 Exchange In Real Estate?
Imagine an investor owning a rental property that has appreciated in value wishes to reinvest in another property. To maximize their investment and defer capital gains taxes, they can opt for a 1031 exchange. The investor would use the proceeds from selling the original rental property to purchase a new one.
Timing is crucial in a 1031 exchange. The IRS mandates that investors identify a replacement property within 45 days of selling the original property and complete the purchase within 180 days. This tight timeframe can create pressure, particularly in competitive markets.
Investors often collaborate with real estate agents and qualified intermediaries to navigate these challenges. A real estate agent can help locate replacement properties, while an intermediary manages the exchange process and ensures compliance with IRS regulations.
Types of 1031 Exchanges
You should explore three types of tax-deferred exchanges: delayed exchanges, reverse exchanges, and build-to-suit exchanges.
Delayed Exchange
The delayed exchange is the most common format. It allows investors to sell a relinquished property and then purchase a replacement property within 180 days.
If you sell the relinquished property before acquiring the replacement, the proceeds from the sale go to a qualified intermediary. This intermediary holds the funds until you’re ready to purchase the replacement property, at which point they transfer the money to the closing agent.
Reverse Exchange
In a reverse exchange, you purchase the replacement property before selling the relinquished one. This option can be advantageous in a seller’s market where competition is fierce or when you need to secure a desirable property quickly.
When using a reverse exchange, the replacement property must be held by an exchange accommodation titleholder (essentially, the qualified intermediary) until the relinquished property is sold.
Build-To-Suit Exchange
Also known as a construction or improvement exchange, a build-to-suit exchange allows you to use the deferred tax dollars from selling your investment property to fund renovations on the replacement property. These improvements must be completed within 180 days.
How to Make a 1031 Exchange
If you're considering a 1031 exchange, here’s a general overview of the process:
1. Identify The Property You Want To Sell and Buy
Start by deciding which property you want to sell (the relinquished property) and which property you want to acquire in exchange (the replacement property). Both properties must be "like-kind," meaning they should be similar in nature, though not necessarily identical in quality or grade.
2. Choose A Qualified Intermediary
You’ll need to work with a qualified intermediary, also known as an exchange facilitator, to manage the 1031 exchange.
This intermediary will handle the sale of your relinquished property, purchase the replacement property on your behalf, and transfer the deed to you. They will also hold your sale proceeds in escrow until the exchange is finalized.
3. Tell The IRS About Your Transaction
Finally, you must report the 1031 exchange to the IRS by filing Form 8824 with your tax return. This form requires you to provide details about the properties involved in the exchange, a timeline of the transactions, the parties involved, and a summary of the financial aspects of the deal.
The properties involved in the exchange must meet specific criteria:
- Relinquished Property: The property you intend to sell is referred to as the relinquished property, also known as Phase 1 or the downleg in a 1031 exchange. This property is exchanged for another similar property.
- Replacement Property: The property you plan to acquire is called the replacement property. It’s the "like-kind" asset purchased with the proceeds from the sale of the relinquished property, sometimes referred to as the up leg of the exchange.
Special Rules for Depreciable Property
Special rules come into play when exchanging depreciable property, potentially triggering a profit known as depreciation recapture, which is taxed as ordinary income.
Generally, swapping one building for another allows you to avoid this recapture. However, if you exchange improved land with a building for unimproved land without one, any depreciation claimed on the building will be recaptured as ordinary income.
These complexities highlight the importance of seeking professional assistance when executing a 1031 exchange.
Changes to 1031 Rules
Before the Tax Cuts and Jobs Act (TCJA) was passed in December 2017, some exchanges involving personal property like franchise licenses, aircraft, and equipment, qualified for a 1031 exchange. Now, only real property, as defined in Section 1031, qualifies.
However, the TCJA’s full expensing allowance for certain tangible personal property might help offset this change in tax law.
The TCJA includes a transition rule that allowed a 1031 exchange of qualified personal property in 2018, provided the original property was sold, or the replacement property was acquired by December 31, 2017. This rule applies specifically to the taxpayer and doesn’t permit a reverse 1031 exchange, where the new property is purchased before the old one is sold.
1031 Exchange Timelines and Rules
Traditionally, a 1031 exchange involves a straightforward swap of properties between two parties. However, finding someone with the exact property you want who also wants your property is rare.
As a result, most exchanges are delayed, three-party, or Starker exchanges (named after the landmark tax case that permitted them).
In a delayed exchange, a qualified intermediary (or middleman) holds the proceeds from the sale of your property and uses them to purchase the replacement property on your behalf. This arrangement is treated as a swap for tax purposes.
There are two critical timing rules in a delayed exchange:
45-Day Rule
The first rule pertains to identifying a replacement property. After selling your property, the intermediary receives the proceeds. You cannot receive the cash, or it will disqualify the 1031 exchange. Within 45 days of the sale, you must designate the replacement property in writing to the intermediary, specifying which property you intend to acquire.
The IRS allows you to identify up to three properties as long as you close on at least one of them. You can designate more than three if they meet certain valuation tests.
180-Day Rule
The second rule concerns the closing of the new property. You must complete the purchase of the replacement property within 180 days of selling the original property.
Reverse Exchange
It’s also possible to purchase the replacement property before selling the old one while still qualifying for a 1031 exchange. In this scenario, the same 45- and 180-day timeframes apply.
To qualify, you must transfer the new property to an exchange accommodation titleholder, identify the property for exchange within 45 days, and complete the transaction within 180 days after acquiring the replacement property.
1031 Exchange Tax Implications: Cash and Debt
You may end up with cash left over after the intermediary acquires the replacement property. If that happens, the intermediary will give you the remaining cash at the end of the 180 days.
This leftover cash, known as "boot," will be taxed as part of the sales proceeds from your original property, typically as a capital gain.
A common pitfall in these transactions isn’t taking loans into account. It's crucial to consider any mortgage loans or other debts on both the property you're relinquishing and the replacement property. Even if you don’t receive cash back, a reduction in your debt liability will be treated as income, just like cash.
For example, if you had a $1 million mortgage on the old property, but the mortgage on the new property is only $900,000, that $100,000 difference will be considered a gain, classified as boot, and will be subject to taxes.
1031 Exchange FAQs
Here are answers to some common questions about 1031 exchanges:
When Should I Not Do a 1031 Exchange?
The main goal of a 1031 exchange is to reinvest your sale proceeds into a "like-kind" investment property, such as using the funds to pay off debt or make a down payment. If you need the cash from the sale of your investment property for any other purpose, it may be wise to reconsider doing a 1031 exchange.
How Long Do I Have to Hold a 1031 Exchange?
While the IRS doesn’t set a specific holding period, it’s generally recommended to hold the property for at least one year. This is because the IRS taxes capital gains based on the duration of ownership, with long-term capital gains being taxed at a lower rate.
Which Types of Properties Qualify for a 1031 Exchange?
Rental properties, commercial buildings, and vacant land are eligible for a 1031 exchange. However, primary residences and second homes don’t qualify.
The Bottom Line
A 1031 exchange can be a valuable tool for real estate investors looking to acquire more profitable properties, expand their portfolio, defer capital gains taxes, and continue reinvesting.
Due to its strict requirements and deadlines, a 1031 exchange can be complex. It's essential to work with a qualified intermediary who can manage the process and ensure that everything complies with IRS regulations.
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