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- A 1031 exchange lets you sell one property, buy another, and avoid capital gains tax in the process.
- There’s a strict time limit on 1031 exchanges. You must purchase your new property within 180 days.
- A 1031 exchange can help you buy more profitable properties, diversify, or defer taxes associated with depreciation.
Defining a 1031 exchange
A helpful tax strategy
A 1031 exchange involves swapping one kind of investment real estate property for another and receiving tax benefits as a result. Named after Section 1031 of the U.S. Internal Revenue Code, these exchanges allow the participant, which can be an individual or entity, to defer taxation on the property sold as long as the proceeds are used toward a similar investment within a certain time frame.
As Adam Kaufman, co-founder and chief operating officer of real estate crowdfunding platform ArborCrowd, explains: “By using 1031 exchanges, real estate investors are able to sell a real estate asset and reinvest the proceeds into a like-kind investment — another real estate asset — and defer the capital gains tax associated with the transaction.”
Key rules of 1031 exchanges
“Like-kind” property
There are some very specific 1031 exchange rules that investors must follow if they want the benefits of these swaps. First of all, properties must be the same type or “like-kind” to be involved in a 1031 exchange. The IRS defines this term broadly, stating in a 2008 fact sheet that “Like-kind property is property of the same nature, character or class” and that “Quality or grade does not matter.”
The document adds that “Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land.”
The fact sheet goes on to highlight a few exceptions. “One exception for real estate is that property within the United States is not like-kind to property outside of the United States,” it states. “Also, improvements that are conveyed without land are not of like kind to land.”
1031 exchange types and time restrictions
Technically, there are several types of 1031 like-kind exchanges, including delayed exchanges, built-to-suit exchanges, reverse exchanges, and others.
The exact 1031 exchange process depends on the type you’re using, but no matter what kind of 1031 exchange you are using, there are time restrictions.
Delayed exchanges
Most 1031 exchanges are delayed exchanges, which work like this: First, you’d determine the property you want to sell, and identify the exchange facilitator you want to handle the transaction.
Insider
Then, like many investors, you’ll probably want to have a qualified intermediary hold the proceeds of your sale until you’ve identified the property or properties you’d like to purchase. After that, you have 45 days to find potential replacement investments and 180 days to make a purchase.
Build-to-suit exchanges
A build-to-suit 1031 exchange allows an investor to use the proceeds of their property sale to not only purchase a new investment but fund improvements on the replacement property, too. As with other exchanges, the value of the replacement property (after improvements) must come out to be equal to or greater than the sale proceeds of the initial property.
Reverse exchanges
In a reverse exchange, the replacement property is purchased first, and then the initial property is relinquished afterward.
Insider
As in a delayed exchange, both steps must occur within 180 days. You’d use an exchange accommodation titleholder to retain the property while you sell your previous one.
Using a qualified intermediary
One option available to investors interested in participating in 1031 exchanges is working with a qualified intermediary, a party that will hold the proceeds of any property sold and use these funds to purchase the replacement property.
Why use a 1031 exchange?
These swaps may sound complicated, but there are many reasons you might use a 1031 exchange.
One major draw is deferring capital gains taxes on the sale of a real estate property. By using one of these swaps, an investor might be able to build wealth more quickly.
Another significant perk is using one of these exchanges to diversify one’s portfolio. By using a 1031 exchange, an investor could swap one kind of real estate property for another.
“In a typical real estate transaction, an investor can expect to pay as much as 40% of the taxable gain,” says Paul Getty, president and chief executive officer of financial advisory First Guardian Group. “Now, with a 1031 exchange and with the ability to defer those capital gains taxes, investors can seek out a different sort of investment, diversify their holdings, expand their portfolio, or realign their investments with their long-term goals.”
You can also use a 1031 exchange to buy a property with better cash flow or reset the clock on depreciation. Depreciation essentially allows you to pay less in the way of taxes as a property experiences wear and tear over time. For residential rental properties, the benefit is gradually spread out over 27 ½ years.
Typically, if you used depreciation to your advantage, then you’d owe what’s known as depreciation recapture — or income taxes on the financial gains you realized from doing so — once you sell the property. Using a 1031 exchange can allow you to push these payments out to a later date.
While deferring these taxes (and capital gains) is a nice benefit, 1031 exchanges aren’t free. You’ll still owe a variety of closing costs and other fees for buying and selling a property. Many of these may be covered by exchange funds, but there’s debate around exactly which ones. To find out which costs and fees you may owe for a 1031 exchange transaction, it’s best to talk to a tax professional.
Quick tip: The 1031 exchange is intended for investment properties. There are loopholes that can allow you to use a 1031 exchange on a primary home, but it involves renting the property out a certain amount of time and limiting how much you stay there. Details can be found on the IRS website.
1031 Exchanges: Conclusion
A 1031 exchange transaction can help you avoid short-term capital gains taxes and grow your wealth more quickly through real estate.
They are complicated purchases, though, so make sure you have an experienced intermediary on your side, and consider consulting a tax professional before moving forward. This can ensure you make the best decision for your long-term financial health.
FAQs
Only investment properties qualify for 1031 exchanges. Technically, you can use a primary residence in a 1031 exchange, but only if you meet certain requirements, more specifically renting it out part of the time and limiting the amount of time you stay there.
Like-kind properties are similar. However, there are specific restrictions you must observe to take part in a 1031 exchange, and it can help to consult a financial advisor or tax professional.
There is no limit to how many 1031 exchanges you can do, as long as you fulfill the requirements associated with these swaps.
Yes, 1031 exchanges come with strict rules and deadlines. If you want to participate in one, you can benefit greatly from consulting professionals like financial advisors and tax experts.
There are companies that specialize in providing such services. You may want to obtain referrals from relevant professionals like financial advisors or tax experts.
