Investment property owners need to review their portfolios regularly to identify new opportunities as the market changes. In many instances, owners may want to sell existing property in exchange for different real estate opportunities. If you decide to sell your real estate, you could be required to pay capital gains taxes.

In these cases, you should consider whether you want to take advantage of a 1031 tax-deferred exchange. This exchange practice outlined in Internal Revenue Code (IRC) Section 1031 allows investment property owners to sell their properties for like-kind properties and defer capital gains tax. In addition to the tax deferral benefits, the 1031 exchange can potentially appreciate or produce a cash flow through the reinvestment of proceeds.

Read the full 1031 exchange guide or jump ahead to a specific section:

What Is a 1031 Exchanges?

A 1031 exchange in real estate — also called a like-kind exchange — is a type of tax-deferred exchange that allows real estate investors to defer capital gains taxes when selling one investment property for another. A 1031 exchange is named after the Section 1031 provision in the IRC tax code.

This exchange involves using the proceeds from the sale of the relinquished real estate investment property to acquire another like-kind piece of real estate. The new property has to be of equal or greater value than the one that is sold, and all of the cash profits must be reinvested. This is the only way to defer 100% of the tax on the gain of the sale.

There are plenty of reasons to do a 1031 exchange and open up new opportunities for property ownership. Here are just a few situations in which a 1031 exchange may be an excellent choice for you:

  • Exchange existing property for property with better long-term prospects
  • Exchange existing property for property that will diversify your assets
  • Exchange property you manage on your own for already managed property
  • Exchange multiple properties for one
  • Exchange one property for multiple ones
  • Exchange properties to reset depreciation
  • Expand real estate holdings for the sake of inheritances

By completing the exchange, the taxpayer can build wealth, maximize their purchasing power for replacement properties, save taxes normally due upon the sale, and dispose of investment assets to acquire new ones. To reap the benefits of this practice, investors must identify and close on the replacement property within a specific time limit.

Of course, the goal of a 1031 exchange is 100% tax deferral, but this requires investors to put all of the proceeds from the sale of their relinquished property toward the exchange property. With a partial exchange, investors can keep some of the proceeds and pay some of the capital gains taxes owed. The proceeds kept are called boot. In most cases, investors aim to avoid boot to prevent tax liabilities and gain the full benefits of a 1031 exchange.

The Internal Revenue Service (IRS) has established rules that limit the use of these properties for business, investment, and trade purposes only. For instance, a taxpayer cannot exchange their rental unit property for a personal vacation home. A 1031 exchange may also be referred to as a Starker exchange or used as a verb, such as saying, “We should 1031 that building for this one.”

With a 1031 exchange, investors can use the delayed method — selling their former property before acquiring the replacement — or they can swap them at the same time. This is known as a simultaneous tax-deferred exchange. In this process, the taxpayer closes on the relinquished property and the replacement property on the same day.

Considering the rules and regulations involved, however, it is highly recommended that investors work with a professional with experience in 1031 exchanges to ensure the process is handled correctly.

How Do 1031 Exchanges Work?

The IRC tax code outlines specific rules and procedures to follow for a compliant 1031 exchange. 1031 exchanges work by using the following process:

Involve a Qualified Intermediary

Once you’ve initiated a delayed 1031 exchange, you must retain a Qualified Intermediary (QI), which is essential to the completion of a successful 1031 exchange. A Qualified Intermediary is a person or company that manages the funds involved after a real estate investor sells their relinquished property and looks for a replacement.

The QI sells your property on your behalf, buys the new replacement property, and then transfers the deed to you. A QI has no stakes in the exchange and holds on to the proceeds from the sale of your property, then transfers the funds to the seller of the replacement property or properties.

The reason for using a QI is for them to act as a third party. It is the responsibility of the Qualified Intermediary to hold the proceeds, prepare the legal documents, and attempt to ensure that the transaction is completed within the IRS guidelines. The QI facilitates delayed exchanges and ensures the funds from the sale are compliant. This enables them to remain nontaxable while the 1031 exchange is completed.

The seller has an identification window of 45 calendar days to identify a like-kind property to complete the exchange. As many as three potential new properties can be identified without regard to cost. No formal filing is required to be made with the IRS. However, it is the responsibility of the Qualified Intermediary to accept the list on behalf of the IRS and document the date it was received.

Once this window closes, and like-kind properties are not identified, the 1031 exchange is considered failed, and funds from the property sale are considered taxable. No extensions are allowed under any circumstances, including holidays.

According to the IRS’s definition of like-kind, “properties are of like-kind if they are of the same nature or character, even if they differ in grade or quality.” Like-kind relates to how the properties will be used. The old property, as well as the new property, must be held for investment or utilized in a trade or business. It is important to note that investors and developers who strictly “flip” or resell properties do not qualify for exchange treatment because their intent is resale rather than investment. This also does not include personal properties, such as the seller’s primary residence.

1031 Identifications

Due to this slim identification window, investment property owners are strongly encouraged to research and coordinate an exchange before selling their property and initiating the 45-day countdown. Fortunately, investors have multiple identification strategies available, which are summarized in three rules:

  1. Three Property Rule: Also known as the Three Property Identification Rule, it enables investors to identify up to three like-kind replacement properties, whatever their fair market values are. After identification, the investor could then acquire one or all of the three identified like-kind replacement properties through the 1031 exchange process. This method is the most popular 1031 exchange strategy for investors, as it allows them to have backups if the purchase of their preferred property falls through.
  2. 200% Rule: The 200% Fair Market Value Identification Rule states investors can identify an unlimited number of like-kind replacement properties, provided the total value of all properties at the end of the period doesn’t exceed 200% of the relinquished property’s total net sales value. If an investor wants to perform a 1031 exchange on a property with a sales value of $1 million, they can identify as many replacement properties as desired as long as those properties’ total value doesn’t exceed $2 million. This strategy is often preferred by investors looking to acquire over three investment properties or seeking extra backup properties if a sale falls through.
  3. 95% Exception: The 95% Identification Exception states investors can identify an unlimited number of potential replacement properties with an unlimited fair market value, provided the investor acquires and closes on 95% of the identified market value. Using this exception may be an intentional choice if the investor seeks to purchase multiple properties. It may also happen inadvertently from sudden property value increases. Either way, this gets around the 200% rule while still meeting 1031 exchange requirements.

It’s important to note that if the investor fails to identify properties or identifies more properties than allowed by the Three Property Rule or the 200% Rule and cannot apply the 95% Exception, then the 1031 exchange is considered failed.

1031 Property Identification

Once the replacement properties are identified within 45 days of selling the relinquished property, the seller has an additional 135 calendar days to purchase a replacement property to complete the exchange. Investors must purchase a replacement property or properties and have a Qualified Intermediary transfer the held funds within 180 days from the sale of the relinquished property.

This means they have to purchase a replacement property or properties and have the Qualified Intermediary transfer the funds by the 180-day mark. This window may be shorter if the due date of the income tax return for the tax year in which the previous property was sold falls within the 180-day window. In this case, the sale is due by the tax return date. If the deadline passes before the sale is complete, the 1031 exchange is considered failed, and the funds from the property sale are taxable. There are no extensions.

Another point of note is that the individual selling a relinquished property must be the same as the person purchasing the new property. The name must match between the tax returns and titles of the old and new properties for the exchange to qualify for the 1031 rule. The only exception to this rule applies to cases of single-member limited liability companies (SMLLCs).

New and old property titles cannot be in the same name at the same time. If you find an investment opportunity that you must act on before you have sold your current property, someone other than the taxpayer will hold legal title in what is commonly referred to as a qualified parking arrangement. Once the old property is sold, the proceeds will be directed to the temporary titleholder. Then the property may be transferred from the parking arrangement directly to the taxpayer.

The single-member limited liability company may be treated as equivalent to the sole member of the organization. For example, if John Smith is the sole member of J. Smith Investments, LLC, he may sell a property under his name, purchase it under J. Smith Investments, LLC and still qualify under the 1031 code, as they are considered equivalent entities.

1031 Marketplace

When you file your tax return, complete and file IRS Form 8824. This form describes the details of your 1031 exchange, including the:

  • Properties involved in the exchange.
  • Timeline of the exchange.
  • Key parties involved in the exchange.
  • Monies and finances involved, including the amount of gain deferred.

Examples of 1031 Property Exchanges

Examples of 1031 Property Exchanges

The rules for performing a 1031 property exchange can be confusing on the surface, but these guidelines are relatively straightforward. The broad definitions for what qualifies for a 1031 exchange allow for a wide variety of properties to be exchanged, which offers a wider range of opportunities for investors. Below are a few examples to help you understand what types of exchanges can and cannot be performed.

Some examples of exchanges that can be performed under the 1031 rules include:

  • Exchanging any business, investment, or trade property for another, including raw land, rental property, farmland, industrial buildings, residential rental property, and retail rental spaces.
  • Exchanging property in one state for property in another state.
  • Exchanging one large property for three smaller properties that add up to equivalent or greater value.

Some examples of exchanges that cannot be performed under the 1031 rules include:

  • Exchanging primary residences that have not been converted into rental properties.
  • Exchanging a primary residence for a business property of any type.
  • Exchanging a property that is held primarily for sale, including property held by a flipper or stocks, bonds, or notes.
  • Exchanging real estate property for personal property, including artwork, aircraft, or boats.
  • Exchanging property in the U.S. for property in a foreign nation.

There are some exceptions to this rule, however. If you’ve heard of investment property owners using the 1031 provision to swap out vacation homes and residences, this is possible with some restrictions. As of 2004, Congress modified rules on 1031 exchanges, so taxpayers must have used a residence as a rental property with tenants before selling it through a 1031 exchange. Although there is no set-in-stone timeframe, typically a residence is recommended to have been used for a minimum of 24 months as a rental property before it can qualify for a 1031 exchange. This amount of time should show the IRS that the intent of the property was for productive use.

A similar rule applies to swapping out property to use as a primary home. As of an IRS safe harbor rule implemented in 2008, a property purchased under Section 1031 must meet the following requirements for two years after its purchase:

  • The property must be rented to a tenant who is not the buyer for a minimum of 14 days per each 12-month period.
  • The buyer cannot use the property for their own personal use for more than 14 days per 12-month period or 10% of the number of days during which the property is rented to a tenant.

Provided that these rules are followed, residences may technically be bought and sold using a 1031 exchange. However, it’s critical to ensure the replacement property follows all 1031 guidelines and tax regulations to avoid nullifying the exchange.

If you do not know whether your property will qualify for a 1031 exchange, work with a specialist in the field who can guide you through the process.

What Happens After the Exchange?

Once this process is complete, the seller does not have to pay the full amount of capital gains taxes they would have paid under normal circumstances. If they purchase replacement properties at or above the value of their relinquished property, they do not need to pay any taxes at all. Instead, those taxes are deferred indefinitely if you never perform another property sale.

what are 1031 exchanges

If the seller performs another property sale after a 1031 exchange, they have a few options:

  1. They can sell the property without a 1031 exchange, in which case they will need to pay all current and deferred capital gains taxes.
  2. Alternatively, they can use the 1031 exchange rule again and defer the taxes on the subsequent sale as well. Under current regulations, there is no limit on how many times an investor can perform a 1031 exchange, provided they follow the rules and regulations outlined by the IRC.

However, as a general rule, real estate investors should hold onto their property for a minimum of two years before executing a 1031 exchange. Otherwise, the IRS may suspect the investor of “flipping,” or reselling a property for a quick profit.

1031 Exchange Properties as an Inheritance

Upon the death of the original seller, any deferred capital gains taxes from 1031 exchanges are erased. The properties purchased using the exchange then pass on to the seller’s heirs without the deferred taxes.

Additionally, the heir receives the property with a step-up in basis. This means the property is inherited with a cost basis matching its current market value, not the value at which the property was purchased by the original seller.

For example, say that a property is originally purchased for $500,000. Years later, the property has a fair market value of $800,000. The seller dies and passes it along to an heir. The heir inherits that property with a cost basis of $800,000, not the original $500,000.

If the heir sells the property immediately at fair market value, they would not need to pay capital gain taxes since there is no difference between the cost basis and the property’s sale price. If the heir waits a few years and sells the property when it is valued at $1 million, they would have to pay capital gains taxes on the $200,000 difference between the cost basis and the sale price. Alternatively, the heir can perform a 1031 exchange and defer capital gains taxes, restarting the process.

Benefits of 1031 Exchanges

Benefits of 1031 Exchanges

If you go this route and exchange your property, what are the advantages of a 1031 exchange? Some 1031 exchange benefits include:

 

1031 exchanges allow investors to defer the capital gains tax, so they can use the entire proceeds from a sale to purchase larger properties instead of paying a portion of those proceeds toward taxes. By minimizing the loss of purchasing power, investors can grow their wealth more quickly and open up more opportunities for investment.

The deferred taxes owed to the IRS after performing 1031 exchanges are erased upon the seller’s death. As long as the seller continuously performs 1031 exchanges to purchase larger properties through their lifetime, they can grow their wealth tax-free and pass it on to their heirs, who will inherit the properties without the deferred taxes.

Long-term capital gains have a maximum tax rate of 20%, with depreciation recaptured at 25%. Because a 1031 exchange allows investors to defer their federal and state taxes on the new investment property, they can use that extra cash towards a wider range of purchasing options. Depending on the property’s price, taxpayers may have access to thousands or hundreds of thousands of dollars to invest in a larger property or potentially receive a higher loan.

With more funds available immediately after the sale, investors can work with their Qualified Intermediary to acquire multiple properties in a single exchange to diversify their portfolios. Investors can also consolidate several properties into one to make property management easier, such as exchanging two duplexes for a retail strip center or one property in a more expensive state for three in a more affordable one.

This flexibility makes managing investment risk more efficient, enables investors to adjust properties based on their desired level of involvement and allows them to take advantage of new opportunities across the U.S.

1031 Marketplace

Investors have the potential to bring in additional income year after year by investing in more valuable and profitable properties through a 1031 exchange. For instance, investors can use the funds from the sale that won’t be taxed to exchange vacant land for a commercial building that generates a steady income and depreciation benefits

Drawbacks of 1031 Exchanges

While the benefits are attractive for investors, there are significant drawbacks to consider as well. Before deciding to move forward with a 1031 exchange, it’s essential to understand the disadvantages. While it can seem like an attractive option, a 1031 exchange won’t work for all investment property owners.

 

1031 exchanges must follow every rule and regulation to the letter or be considered failures. Investment property owners need to know and follow the 1031 guidelines, including what types of properties qualify, how many properties can be identified, what the purchasing guidelines are and more.

Any mistakes can result in a failed exchange. For this reason, it is recommended to work with professionals who are highly familiar with 1031 exchanges to avoid falling outside the rules and harming the exchange’s success. Errors can include:

  • Failing to identify enough properties.
  • Identifying too many properties.
  • Failing to meet the 95% rule.
  • Missing crucial identification and exchange deadlines.

If a seller cannot meet the deadlines for the 45-day identification period or the 180-day exchange period, the 1031 exchange is considered a failure. Therefore, the seller will not be able to defer the capital gains tax from selling their property.

This is especially problematic for those who have large capital gains and/or depreciation recapture taxes owed. Upon this failure, sellers have to pay the capital gains taxes for their recent sale and any sale they have performed in the past that utilized the 1031 exchange rule.

One significant issue that investors may encounter is depreciation. Depreciation is the amount of cost on an investment property that is written off each year due to wear and tear. Capital gains taxes are calculated based on a property’s original purchase price plus improvements and minus depreciation.

If an investor sells a property for more than its depreciated value, they have to recapture that depreciation as part of their taxable income from selling the property. If depreciation is not accounted for in subsequent 1031 exchanges, investors may find that their rental incomes fail to keep up with depreciation expenses.

1031 exchange properties are illiquid. While selling is possible, investors would be required to pay taxes. Most real estate investors who own exchange properties used for investment or business purposes, such as renting, should hold their properties for a minimum of two years to prove the intent of use to the IRS and avoid being disqualified from a 1031 exchange for “flipping.”

Partner with 1031 Crowdfunding

Partner With 1031 Crowdfunding

If you’re interested in performing a 1031 exchange for one of your investment properties, 1031 Crowdfunding can assist you with this.

1031 Crowdfunding was founded with the goal of providing a range of quality properties for investors interested in 1031 exchanges. We ease the stress of the 45-day identification period with a turnkey solution. We provide an online marketplace where investors can find the right replacement property quickly. With our platform, the duration of both the identification period and closing timeline could be reduced to less than a week. Most clients close within three to five days.

To learn more about what our platform is and how it can help you diversify your real estate portfolio, contact 1031 Crowdfunding today or create a free investor account.

 

This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees, and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC, member FINRA, SIPC.

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