Are you a real estate investor wanting to increase your profits, minimize taxes, and scale into larger investment properties?
If so, a 1031 Exchange is an IRS-approved strategy that can empower you to do just that by deferring capital gains taxes when exchanging one property for another.
But the 1031 Exchange comes with attached strings, so it’s imperative to understand the 1031 Exchange rules, regulations, and tax implications surrounding 1031 Exchanges.
In this article, you’ll learn what real estate investors need to know about 1031 Exchanges and how they work.
Table of Contents
What is the 1031 Exchange?
A 1031 exchange is a legal method for savvy real estate investors to defer capital gains taxes when they sell one investment property and use the proceeds to purchase another piece of investment real estate of equal or greater value.
It’s called a 1031 Exchange (or Section 1031 Exchange) because the Internal Revenue Service outlines the requirements of this like-kind exchange in Section 1031-3 of the Internal Revenue Code (IRC).
What is the Purpose of 1031 Exchange?
The code was incorporated into the U.S. tax law in 1921 to prevent taxation on continued investments. The reason the federal government implemented this code is to encourage reinvestment to help maintain the supply and quality of real property across the country.
Who Qualifies for a 1031 Exchange?
Any taxpaying entity—including individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, and trusts—that owns investment or business property may be eligible for a Section 1031 Exchange if they plan to roll the profits into a different like-kind investment or business property.
What are the IRS Rules for a 1031 Exchange?
The Internal Revenue Service requires five essential 1031 Exchange rules to be followed to successfully execute a real estate 1031 Exchange and defer your capital gains tax. These 1031 Exchange rules include the following:
1. You Must Acquire a Like-Kind Property
Both properties in the 1031 exchange must be similar enough to qualify as “like-kind.” The IRS defines “like-kind” property as “property of the same nature, character or class.” The IRS also clarifies that, “Quality or grade does not matter” and “Most real estate will be like-kind to other real estate.”
The phrase “like-kind” has been interpreted generously by the IRS. Because they consider most real estate to be like-kind to other real estate, most transactions are accepted so long as its a business or investment property being exchanged for another business or investment property.
However, some caveats require expert guidance and insight. One example is when exchanging a depreciable property; there’s a possibility that depreciation recapture could be triggered and taxed as ordinary income. If you exchange one building for another, you can avoid this recapture. However, if you exchange something like a multifamily building for vacant land or raw land without any building, the depreciation you previously claimed on the building could be recaptured as ordinary income.
2 . You Must Identify Like-Kind Replacement Property Within 45 Days
According to the IRS, there are two types of properties involved in a like-kind exchange: a relinquished property and a replacement property.
The relinquished property is the property that is sold in the exchange and the replacement property is the property that is acquired in the exchange.
According to the IRS, you have a 45-day deadline from the day you sell your relinquished property to select a potential replacement property of equal or greater value.
The selection must be clearly described in writing, signed by yourself, and given to a relevant party involved in the exchange. In this light, submitting a formal offer is considered sufficient. Notifying your attorney, real estate agent, accountant, or any other agent acting on your behalf is not sufficient.
3. You Must Complete the Exchange Within 180 Days
To defer capital gains taxes, the transactions for both the relinquished property and the replacement property must be finalized by whichever occurs first:
A) 180 days from the date of selling the relinquished property
B) The tax return due date of the year in which the initial property was sold
4. You Must Report the 1031 Exchange to the IRS with Form 8824
Once a 1031 Exchange is completed, it is necessary to report the exchange to the IRS by submitting Form 8824 with the tax return for the year the exchange occurred.
5. You Must Ensure the Exchange is Accepted in the Following Tax Return
After Form 8824 is filed, you’re almost done! The last rule is to wait for the IRS to review and accept your complete tax return. Once they have accepted it, your 1031 Exchange is complete. If they review your return and find any errors with your exchange, you may need to pay taxes, penalties, and interest on your transactions.
What Disqualifies a Property from Being Used in a 1031 Exchange?
Three key events can disqualify a 1031 Exchange. They include:
You don’t identify replacement property of like-kind within 45 days of the sale of your property
You don’t complete the full exchange within 180 days of the sale of your property
You assume the possession of any cash or proceeds from the sale of your property before the completion of the exchange
Many real estate investors work with a qualified intermediary to ensure the funds are appropriately handled and the critical timeline milestones are met.
What is a Qualified Intermediary?
To prevent the early receipt of cash or other proceeds—and to ensure all 1031 exchange rules are met—many real estate investors choose to hire a qualified intermediary or exchange facilitator who can guide them through the process and hold the exchange funds until the exchange is finalized.
Please be aware that it is not permissible for you, your real estate agent, broker, accountant, attorney, employee, or any individual who has held such roles within the last two years to be your facilitator.
When selecting a qualified intermediary, it’s essential to exercise caution due to incidents of intermediaries declaring bankruptcy or failing to meet contractual obligations. These situations have resulted in taxpayers needing more strict timelines for tax deferred exchanges or reverse exchanges, which can disqualify the transaction from Section 1031 deferral of gain. Taxpayers may face taxable gains in the current year, and any losses would be considered under separate code sections. Beware of individuals promoting improper use of like-kind exchanges, as they are typically not tax professionals. Some sales pitches may encourage taxpayers to exchange non-qualifying vacation or second homes, and many promoters refer to these exchanges as “tax-free” rather than “tax-deferred.” Additionally, some may advise claiming an exchange despite possessing cash proceeds from the sale.
What are the different structures of a Section 1031 Exchange?
To carry out a Section 1031 Exchange, there needs to be a transfer of properties. The most basic form of a 1031 Exchange is called a 1031 Exchange and involves simultaneously swapping one property for another.
There are two other ways to structure a 1031 Exchange:
1. Deferred 1031 Exchange
Deferred exchanges (also known as a Delayed Exchange) are more complex but allow more flexibility. A deferred exchange is a great option if you need more time to find another property for a like-kind exchange. Unlike a standard 1031 exchange, a delayed exchange enables you to sell your first property to a qualified intermediary who will purchase it later. After you have identified a new property to acquire, the intermediate will officially buy the first property from you to meet the time requirements of the 1031 Exchange. This enables you to extend the time frame of the whole exchange while still treating it as a single transaction eligible for a 1031 exchange.
2. Reverse 1031 Exchange
In a Reverse Exchange, it is feasible to purchase the replacement property before selling the old one and still meet the requirements for a 1031 exchange. The time limits of 45 and 180 days remain the same in this scenario.
To be eligible for a reverse exchange, you need to transfer the new property to an exchange accommodation titleholder, select a property for exchange within 45 days, and finalize the transaction 180 days after acquiring the replacement property.
What Happens to Leftover Cash in a 1031 Exchange?
Suppose you have cash left over after the intermediary acquires the replacement property, which you will pay at the end of the 180-day period. However, this cash will be taxed as capital gains from the sale of your property, often as a capital gain. Many people run into problems with these transactions because they need to take loans into account. You need to consider any existing mortgage loans or other debts on the other property you’re relinquishing and any debts on the replacement property. Even if you don’t receive cash back but your liability decreases, it will still be considered income, just like cash. For instance, if you had a $1 million mortgage on the old property, but the mortgage on the new property is only $900,000, you’ll have a $100,000 gain that will also be classified as capital gains and taxed accordingly.
When Do You Need to Repay the Deferred Capital Gains Taxes on Investment Property?
You must repay the deferred capital gains tax when you sell the investment property you acquired through a 1031 Exchange.
The deferred capital gains tax will accumulate no matter how often you utilize the 1031 process. So, if you sell after one 1031 exchange, you must pay the deferred capital gains tax on the previous property. If you sell after two 1031 exchanges, you’ll need to pay the deferred capital gains tax on the last two properties, etc.
As you can see, the total amount of tax exposure can increase over decades if you defer capital gains tax. If you do decide to sell, it is imperative to work with a tax professional to determine a good year for you to do it in a way to offset the gains as much as possible.
However, there’s a workaround; that workaround is never to sell—and it’s one of the best estate planning strategies available today.
Using 1031s for Estate Planning
While 1031 exchanges offer tax deferral benefits, a potential downside is that the tax will eventually need to be paid, resulting in a hefty bill. However, there is a way to avoid this. Tax liabilities cease upon death, meaning that if you pass away without selling the property obtained through a 1031 exchange, your heirs will not be responsible for paying the deferred tax. Additionally, they will inherit the property at its current fair market value.
What’s an Example of a 1031 Exchange?
Let’s say that Allison is the proud owner of an apartment building that has doubled in value from $2 million to $4 million since she purchased it. Because of the appreciation, she has a lot of equity sitting in the property that isn’t working very hard for her and it could be earning more of a return if she either acquired a larger property or a few smaller properties.
Allison talks with her real estate broker and learns that there’s a larger apartment building nearby that the owner is thinking about selling. After some negotiation between the two real estate agents and parties, Allison learns she can purchase the larger building if she wants.
After some debate, Allison learns she can hire a qualified intermediary to help follow the 1031 exchange rules and roll the equity of her current building into the larger building while deferring capital gains tax. By following the 1031 exchange rules and working with her tax counsel, Allison is able to avoid paying taxes on a big tax bill and keep more of her money working for her.
What are the Benefits of a 1031 Exchange?
As seen in the example above, the benefits of a 1031 exchange are mainly the deferral of capital gains taxes, depreciation recapture taxes, and other potential tax liabilities from an investment property when it is sold.
This allows real estate investors to invest more money into the replacement property, which could lead to additional growth opportunities. In addition, a 1031 exchange can be used for estate planning purposes so that heirs will not be responsible for repaying any deferred tax liability when inheriting the property. It’s essential also to consider, however, that all deferred taxes will become due at some point. For this reason, a financial advisor should always be consulted before attempting such an exchange.
What are the disadvantages of a 1031 exchange?
The main disadvantage to a 1031 exchange is that all deferred taxes will eventually become due. Additionally, 1031 exchanges can be complicated and require an understanding of the tax code and strict timing requirements for the exchange to qualify for deferral. Furthermore, if any “boot” is received during the exchange, it will be subject to taxation. Lastly, many real estate investors need help finding potential replacement properties to complete their 1031 exchange before the deadline or are unaware of the proper structuring and execution necessary for a successful 1031 transaction.
How long must you hold a 1031 exchange property?
You must hold a new property acquired through a 1031 exchange long enough to justify that you purchased it with the intent to hold it as an investment property and not a quick flip for profit.
If this sounds like a vague answer, you’re not alone. The Internal Revenue Service and Treasury Regulations do not state a clear answer, so we’re left to interpret the law through the examination of case law.
In Private Letter Ruling 8429039 (1984), the IRS stated that a holding period of two years would be sufficient. However, private letter rulings do not set binding legal precedent, and many lawyers argue the two year timeframe for two reasons.
First, if an individual holds an investment property for over 12 months, it will affect their tax returns in two tax filing years. Second, in 1989, congress introduced HR 3150, which suggested that both the relinquished and replacement properties of a 1031 Exchange should be held for at least one year to qualify for tax-deferred treatment. While this proposal was never implemented into the tax code, some tax advisors view it as a sensible minimum guideline.
In short, if you execute a 1031 Exchange, you need to have the intent to hold onto the new property as an investment property and not a quick flip.
Can You Use a 1031 Exchange from One Property to Multiple?
Yes. Properties do not necessarily need to be exchanged on a 1:1 basis. They can be exchanged one for many as long one of the following 1031 Exchange rules are met:
Rule of Three: The exchanger can identify up to three properties.
200% Rule: The exchanger can identify unlimited properties as long as their cumulative value does not exceed 200% of the market value of the relinquished property sale.
95% Rule: The exchanger can identify more than three properties whose value exceeds 200% so long as they acquire 95% of the value of the replacement properties.
Can You do a 1031 Exchange from a Residential Property to a Commercial Property?
Yes, you can exchange a residential property for a commercial property as long as the residential property is “like-kind” in the sense that it is an income-producing rental property that is being exchanged for income-producing commercial real estate assets.
While it’s possible to exchange a primary residence or personal property, there are more hoops to jump through and it can often be more challenging and cost-prohibitive to execute.
For more real estate investing definitions, read The Top 125 Real Estate Investing Definitions You Need to Know. For more information about getting started as a real estate investor, read our Complete Guide to Commercial Real Estate Investing for Beginners.