What Is a 1031 Exchange?

How does a 1031 exchange work?

A 1031 exchange, known as a like-kind exchange, is a real estate investment strategy. It involves selling an investment property and purchasing a similar property within 180 days to postpone paying capital gains taxes.

Section 1031 of the Internal Revenue Service (IRS) Internal Revenue Code allows investors to defer any gain or loss on a property, which can help postpone unwanted capital gains taxes until a later date. This allows real estate investors to sell an unwanted property and purchase another while avoiding a large tax bill, allowing them to keep their capital invested in the market for longer.

Both properties in a 1031 exchange must be of like-kind, meaning they’re of the same type, nature or character, according to the IRS. This means that the property you sell must be similar to the property you purchase as part of the exchange. For example, If you sell an apartment building, you must purchase another apartment building.

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Types of 1031 exchanges

Not all 1031 exchanges are the same. Different versions of this transaction type include:

Delayed exchanges

Delayed exchanges, also called deferred exchanges, are the most common type of 1031 exchange. This is when you close on your old property first and then must close on your new, replacement property within a set timeframe.

Simultaneous exchanges

A simultaneous exchange is the simplest type of 1031 exchange. With a simultaneous exchange, the transactions for both the property you’re selling and the one you’re buying close at the same time.

Reverse exchanges

With this type of 1031 exchange, you purchase your new property before selling your old one.

Eligible properties for a 1031 exchange

Only certain types of properties are eligible for 1031 exchange tax treatment.

“Personal-use properties, such as primary residences or vacation homes, do not qualify for a 1031 exchange,” said Michael Morris, vice president of Kidder Mathews, a commercial real estate firm. “The exchange is specifically designed for investment or business properties.”

According to Morris, under existing IRS regulations, properties eligible for a 1031 exchange include (but are not limited to):

• Commercial real estate assets including office, retail and warehouse properties
• Rental properties to include single-family homes or apartments (as long as they are held for investment purposes)
• Vacant land
• Agricultural property (such as farms and ranches)
• Mixed-use assets having any combination of retail, office and residential spaces

How to do a 1031 exchange

Here are the steps required to perform a 1031 exchange.

1. Find a qualified intermediary

Before selling your investment property, you should find a qualified intermediary to handle the 1031 exchange transaction. This is critical because if you deposit the proceeds from the sale of an investment property, it becomes immediately taxable.

Work with an intermediary who can help with the documentation and details of the transaction, as well as hold the funds from your sale in escrow until the new property is purchased. This keeps your transaction fully qualified in the eyes of the IRS and helps you avoid any mistakes in handling the funds or reporting requirements.

2. Choose the property you want to sell

Choose which investment property you want to sell as part of the exchange. Remember, the new property has to be similar in type and nature, so choose a property that will match the one you are looking to buy.

3. Choose the property you want to buy

Once you have sold your property, you’ll need to identify a property that will replace it. You must share this property with the seller or your qualified intermediary within 45 days.

4. Purchase the new property

Once identified, you need to purchase the new property within 180 days of the sale of the old property to stay within 1031 exchange guidelines. This means you need to close on the property within the time frame to qualify.

5. File your 1031 exchange with the IRS

In the year the 1031 exchange is completed, you’ll need to file IRS Form 8824 to report the sale and purchase of your new property. This ensures you stay in compliance with IRS tax laws.

Advantages of a 1031 exchange

A 1031 exchange can be a great tool for real estate investors. Here are a few advantages:

Defer taxes

A 1031 exchange can be a great way to save money on capital gains taxes and stay invested in the real estate market while upgrading your investment property.

Trade up

Using a 1031 exchange makes it easier to trade one investment property for another, thereby improving your property portfolio and (ideally) making you more money as an investor. Avoiding a large tax bill can help you stay invested in the market and grow your wealth faster.

Build your wealth

Using a 1031 exchange can help you keep more cash, allowing you to invest in more properties without paying additional taxes. This strategy allows you to keep reinvesting your profits into the real estate market, growing your wealth and potentially helping you retire sooner.

Drawbacks of a 1031 exchange

While 1031 exchanges offer some tax advantages, Michael Morris said that there are some risks of doing a 1031 exchange.

Loss of depreciation benefit

It’s possible that doing a 1031 exchange will result in a lower depreciation benefit.

“In a 1031 exchange, the tax basis of the relinquished property carries over to the replacement property,” Morris said. “As a result, the depreciation schedule for the new property will be based on the original purchase price. If the replacement property is acquired at a higher value than the relinquished property, this can result in a lower annual depreciation deduction.”

Changing investment objectives

A 1031 exchange might not work with your investment strategy.

“If you wish to diversify your investment portfolio or switch to a different type of property, a 1031 exchange might not align with your new investment objectives,” Morris said. “For example, if you want to transition from residential rental properties to commercial real estate, it may be more beneficial to sell the existing properties and invest directly in the desired asset class rather than using a 1031 exchange.”

Cash flow considerations

As an alternative, it might be better to put the money toward a different use.

“In some cases, the equity tied up in the relinquished property might be better utilized elsewhere, such as paying off debt, funding other investments, or addressing personal financial needs,” Morris said.

Time and complexity constraints

With a 1031 exchange, you’ll need to make sure you meet specific requirements.

“Completing a 1031 exchange involves adhering to specific timelines, documentation requirements and working with a qualified intermediary,” Morris said. “If you have time constraints, urgency in utilizing funds or prefer simplicity in your transactions, a 1031 exchange may not be the most suitable option.”

FAQ

Bottom line

The 1031 exchange is a powerful investing tool real estate investors can use to defer taxes when selling a property and help bolster their real estate portfolio. But you must follow the IRS requirements to avoid disqualifying the exchange and getting hit with an unwanted tax bill. For this reason, it can help to speak to a tax professional.

“It is important to evaluate your unique circumstances and financial goals, and consult with a qualified tax professional or financial advisor before deciding if a 1031 exchange is the right choice for your specific situation,” Michael Morris said.

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