A 1031 exchange is one of the biggest tax benefits of real estate investing. With a 1031, real estate investors can defer capital gains taxes on the sale of a property. This leaves investors with more capital to invest in their next project, which allows investors to grow their real estate portfolios faster! This is why trading up with a 1031 exchange is one of the best real estate investment strategies.
But 1031 exchanges, named for the section of the internal revenue code that covers them, can be complicated because there are many rules that must be followed to successfully defer your taxes.
In this article, we answer all your pressing 1031 exchange questions:
- What is a 1031 exchange?
- How does a 1031 exchange work?
- What are the 1031 exchange rules?
- Which properties qualify for a 1031 exchange?
- What does the 1031 exchange timeline look like?
We’ll also give you an example of a 1031 exchange, complete with financials so you can see how the tax savings could affect you. Having said that, taxes are highly unique to individuals, so please consult a tax professional to estimate how much you could be paying in taxes from the sale of a specific property.
1031 Exchange Defined: The Basics
A 1031 exchange in real estate is a tool that allows real estate investors to trade one investment property for another, rolling all profit from the sale of the first property directly into the new property to defer the capital gains tax.
In a normal investment property sale, investors pay a capital gains tax based on the profits made from the sale. But with a 1031, all your profit goes directly into your new property, meaning that you don’t actually realize your profit from the sale, so you don’t have to pay capital gains at that point.
You won’t have to pay your capital gains until you sell the property that replaced your first property. And, because you can do multiple 1031 exchanges, you can potentially grow your real estate holdings tax-deferred for your entire investment career!
Tax implications should always be considered as you decide when to sell real estate investments. And using a tax-deferred exchange can help you keep more of your money invested rather than having it lost immediately to taxation.
How Does a 1031 Exchange Work?
A 1031 exchange works in stages.
There are three main steps you’ll need to follow to properly conduct a 1031 exchange.
Step 1: Identify the “Relinquished” Property and Potential “Replacement” Properties
Your relinquished property is the investment property that you will be giving up. Your replacement property is the property that you will gain.
The key to choosing your replacement property is that the property must be “like-kind” with your relinquished property. This is why a 1031 exchange may be called a like-kind exchange.
The like-kind rule implies that the properties must be similar (a single-family home for another single-family home or an apartment building for another apartment building), however, the IRS’s definition of like-kind is more generous than that. You can generally exchange residential property for residential property or commercial property for commercial property. You can even change unimproved land for a developed property. It is worth noting that properties abroad are not considered like-kind with American properties, no matter how similar.
The IRS requires that you identify your replacement property in writing. However, because unexpected issues can cause a real estate deal to fall through, the IRS allows you to name up to three potential replacement properties. To complete your 1031 exchange, you’ll need to close on one of them.
Step 2: Identify Your “Qualified Intermediary”
A qualified intermediary is the trusted third party who will handle the funds from the transaction. Remember, you cannot receive the proceeds from the sale of your relinquished property because realizing the gains would trigger the capital gains tax. So your intermediary will receive the funds from the sale and use them to purchase the new property on your behalf.
Step 3: Document the Details on Your Next Tax Return
IRS form 8824 is used to report the details of your 1031 exchange to the IRS when you file your annual income tax return. This form will record the sales price of the relinquished property, the purchase price of the replacement property, the debt leveraging of each, all relevant closing costs, and the timeline of your transactions. Timelines are particularly important; let’s look at the timeline requirements of 1031 exchanges, as well as other 1031 exchange rules.
1031 Rules and Requirements
There are several rules and requirements that must be met to legally defer your capital gains and reduce your tax liabilities with a 1031 exchange. Here are the main rules and requirements.
1031 Exchange Timeline
It is highly unlikely that you will find a suitable replacement property that will be ready to close on the same day that you close on the sale of your relinquished property. So the IRS has made allowances for a reasonable time to pass between the sale of your old property and the purchase of the new one. When you have time between the transactions, your exchange is said to be a “delayed exchange.”
There are two timeline rules for delayed exchanges: the 45-day rule and the 180-day rule.
The 45-day rule states that you must identify your replacement property (or properties since you can list up to three potential replacements) within 45 days of closing escrow on the sale of your relinquished property.
The 180-day rule states that you must close on the purchase of the new property within 180 days of closing on the sale of your relinquished property.
It is also possible to buy your new property before selling the old; this is called a reverse exchange. The same 45 and 180-day timeframes apply.
Rules for Qualifying Properties
To qualify for a 1031 exchange, the relinquished and replacement properties must meet certain requirements.
- The properties must be like-kind.
- Both must be held as investment properties (primary residences and vacation homes don’t qualify).
- Both properties must be on American soil.
- To defer all capital gains liability, your replacement property must be of equal or greater value than your relinquished property. If the value were less, you would receive proceeds as a result of the transaction (called “boot”), which would be taxable.
- To defer all capital gains, you need to retain your existing level of debt financing. If you were to swap a property with a $500,000 mortgage for one with a $450,000 mortgage, this $50,000 net worth gain would be taxable.
- If you have been claiming rental property depreciation on your relinquished property, you can essentially roll that depreciation schedule to your replacement property. Note: if you exchange a rental property for raw land, the depreciation claimed on your building would be subject to depreciation recapture. Depreciation recapture is the repayment of depreciation deductions claimed on your income taxes. Since there is no building to depreciate on raw land, you cannot roll your existing depreciation schedule into the raw land.
Types of Like-Kind Exchanges
There are a few different types of 1031 exchanges, some of which we have already touched on.
- Delayed exchanges: Exchanges in which there is a delay between the sale of the relinquished property and the purchase of the replacement property of up to 180 days.
- Reverse exchanges: Exchanges in which the replacement property is purchased before the relinquished property is sold.
- Build-to-suit exchanges: Exchanges in which some of the proceeds from the relinquished property are used to fund improvements to the replacement property. This is allowed by the IRS.
1031 Exchange Examples
Here are a few examples of how 1031 exchanges can work in real-world situations.
Simple 1031 Exchange Example
Let’s say you bought a second home as an investment property five years ago. You paid $500,000 then, and the property is now worth $800,000. Without a 1031 exchange, you would be responsible for capital gains taxes on your $300,000 profits immediately upon the sale of the property. Depending on your income tax bracket, your capital gains liability could be up to 20% of your profits, which would mean a tax bill of around $60,000. And, if you have been taking advantage of annual depreciation on your taxes, the amount of deductions used would be due back to the IRS as well.
But with a 1031 exchange, you could swap your investment property for any other residential property. So you decide to buy a small multi-family apartment building for the additional income streams. You acquire the replacement property for $1.2 million, and because the 1031 exchange saves you from a large immediate tax bill, your proceeds are enough to make a substantial down payment on your new building. Your capital gains taxes and depreciation recovery are both deferred.
1031 Exchange Example with Boot
“Boot” is the proceeds received from a 1031 exchange. If you’re planning to defer all capital gains tax, you would need to purchase a property of equal or greater value than your relinquished property andyou would need to maintain equal or greater debt with your replacement property. Here is an example.
Let’s say you bought an apartment building for $1.2 million three years ago. The building is now worth $1.4 million, but you found a building with lower maintenance expenses and higher rental income, for $1.5 million, so you decide to upgrade with a 1031 exchange.
At the time of the exchange, you have a loan balance of $800,000 on your current building. You can afford to put down enough on your new property so that you only need a $600,000 loan.
If you make the exchange on these terms, your debt liability decreases by $200,000. This is treated as boot and is immediately taxable. If your income bracket puts you in the 20% capital gains rate, you would owe $40,000.
This $40,000 tax bill can be deferred by using financing to maintain a debt of at least $800,000 on your new property.
1031 Exchange Example with Vacation Home
Vacation homes do not qualify for 1031 exchanges, but you can convert the vacation home to an income-producing rental, then complete a 1031 exchange.
To convert your vacation home to a rental, you must find a renter willing to pay market rent for a “reasonable time.” The longer the rental, the easier it is for the IRS to confirm that the property is a qualified investment property.
So you get a renter with a one-year lease. At the end of the lease term, your renter moves out, and you have established the home as an investment property. So it now qualifies for a 1031 exchange.
You bought the home 20 years ago for $100,000. It is now worth $500,000, and you own it free and clear. You choose to invest in a duplex with a purchase price of $700,000. As long as all of your proceeds are put into the new purchase, you can defer the capital gains taxes and depreciation recovery.
Here are direct answers to some of the most commonly asked 1031 exchange questions.
Can you do a 1031 exchange on a primary residence?
No. Primary residences don’t qualify for 1031 exchanges. However, if you convert your primary residence into a rental property by renting it out for a reasonable time, it can qualify for a 1031 exchange in the future.
Can you live in a 1031 exchange property?
Not right away. You must show the IRS that you purchased the property as an investment by renting out the property. According to the IRS, you must rent the property out for at least 14 days in each of the first two years of ownership. You also can’t use the property personally for more than 14 days (or 10% of the days rented, whichever is greater) in each of the first two years.
What happens when you sell a 1031 exchange property?
When you sell a property that you purchased with a 1031 exchange, your deferred taxes become due and payable. However, you can opt for another 1031 exchange to continue the deferment.
How much do you have to reinvest in a 1031 exchange?
There is no set amount that you must invest in a 1031 exchange, but if you’re looking to defer all capital gains taxes, your new property must be of equal or greater value than the old property and have at least as much debt as the old property.
What qualifies for a 1031 exchange?
Any real property (land and improvements) held for investment purposes can qualify for a 1031 exchange, as long as the relinquished property and the replacement property are of like-kind.
Can you avoid taxes with a 1031 exchange?
A 1031 exchange defers capital gains taxes but does not eliminate them. This deferment allows you to grow your real estate portfolio faster by rolling more capital into your next deal, but when you sell your replacement property, you will owe taxes on the gains your originally deferred.
Consider Gatsby Investment
From 1031 exchanges to rental property depreciation, real estate investing can get complicated. Here at Gatsby Investment, we aim to make investing as simple and profitable as possible. Gatsby offers unique 1031 exchange investment opportunities. Contact us for more information, and start expanding your portfolio today!