What is a 1031 Exchange?

Real estate investing is certainly one of the most tried-and-true methods of building long-term wealth, with a myriad of benefits to consider. Real estate can be a great asset for generating cash flow and appreciation, but perhaps the most often overlooked benefit is the variety of special tax advantages that are available to real estate investors.

So, what is a 1031 exchange? Simply put, it is a way to defer capital gains taxes when swapping one real estate investment for another, provided that certain conditions are met. Also referred to as a “like-kind exchange,” the 1031 exchange is named after Section 1031 of the Internal Revenue Code. This strategy is often touted by real estate agents, tax professionals, and financial advisors as a unique way to minimize your tax liability and build significantly more wealth over time.

Under normal circumstances, the sale of a rental property could potentially trigger a large tax bill. However, if you’re able to check all of the boxes outlined below to qualify for a 1031 exchange, the IRS will let you kick the can down the road and defer that tax liability until you eventually sell the next property. And the best part? There’s no limit to how many 1031 exchanges you can perform, or how often you do them. So in theory, you could keep exchanging one property for another and never actually pay the accruing capital gains taxes!

Originally, a 1031 exchange could be completed with various types of personal property, such as business equipment, franchise licenses, or even aircraft. However, the Tax Cuts and Jobs Act, which passed in 2017, limited the scope strictly to real estate, or more specifically, “real property that is held for use in a trade or business or for investment.”

In order to be eligible for a 1031 exchange, the first test to pass is that the “relinquished property” (the asset you sell) and the “replacement property” (the asset you purchase) must be considered “like-kind.” You might think that the IRS holds a very restrictive and narrow view of what makes two properties “like-kind,” but the allowable interpretations are actually rather liberal.

For example, if the relinquished property that you sell is a duplex, the replacement property that you purchase doesn’t necessarily also have to be a duplex. You can “exchange” a duplex for a triplex, an unimproved lot for a single-family home, or even a retail building for an apartment complex. As long as both properties meet the IRS requirement of “real property that is held for use in a trade or business or for investment” and are located within the United States, you’ll likely pass this test.

Regardless of how much equity you have in the property being sold, the sales price of the replacement property must be of equal or greater value than the relinquished property in order to get the full benefit of the 1031 exchange and defer 100% of the capital gain.

For example, if you sell a property for $1 million, you want to make sure to purchase another property for at least $1 million. The IRS even allows investors to spread this out across multiple properties, as long as all of the other rules and timelines are met. This means that you could sell a property for $1 million and purchase two new properties for $500,000 each, or even purchase four new properties for $250,000 each and still meet the requirements of the “equal or greater value” rule.

In some circumstances, it is possible to get the partial benefit of a 1031 exchange and defer some of the capital gain liability, but still be on the hook for some taxes. If the replacement property is not of equal or greater value than the relinquished property, and you end up either receiving cash and/or decreasing your debt position, then that amount will be treated as taxable income to you.

For example, if you sell a property for $1 million that you had originally purchased for $500,000 several years prior, and then purchase a property for $900,000 as part of a 1031 exchange, there will most likely be some net proceeds left over for the qualified intermediary to distribute to you after everything is said and done and the closing costs have been paid. In this scenario, you’ll be able to defer a large portion of the actual capital gain that you would normally have been taxed on, but the net amount of cash you receive back after closing on the new property will be subject to capital gains tax.

In another example, let’s say you sell a property for $1 million that has a mortgage balance of $300,000 and an equity position of $700,000. Suppose that you use all of the equity to purchase a new property for $700,000 free and clear with no new debt. Even though there would be no leftover proceeds for the intermediary to distribute to you because your amount of debt is lower on the replacement property than it was on the relinquished property, that difference would be considered income to you for tax purposes.

The word “exchange” may imply that you’re selling and purchasing at the same time, but this process can actually be delayed over a fairly significant period of time. There are two very strict timelines that you must be aware of when considering a 1031 exchange: The 45-Day Rule and the 180-Day Rule.

The 45-Day Rule refers to the timeframe during which you must “designate” or “identify” a replacement property once you’ve closed on the sale of the relinquished property. It’s important to note that the proceeds from this sale must be held in escrow by a “qualified intermediary” (QI) until closing on the next property has occurred. If you receive any of the cash from the sale, you’ll be ineligible for a 1031 exchange.

Within 45 days of the sale, you must provide written notice to the qualified intermediary with a list of properties that you’ve identified as viable replacements. As long as you end up closing on one of these designated properties within the allotted time, you’ll be in good shape.

The next timeframe to be aware of is the 180-Day Rule, which refers to the deadline by which you must complete the purchase of the replacement property. It’s important to note that both the 45-day clock and the 180-day clock start ticking at the same time, once you’ve closed on the sale of the relinquished property. For example, if you notify the qualified intermediary in writing with your list of identified properties 30 days after the sale of the relinquished property, you will have 150 days remaining to successfully close on the replacement property.

Although much less common, it is possible to perform a “reverse exchange,” where you close on the purchase of the replacement property before actually selling the property that you intend to swap. In order to accomplish this, the investor must utilize the services of an “exchange accommodation titleholder” (EAT). Similar to how a QI holds funds in between transactions, an EAT holds title to the replacement property until the relinquished property is actually sold.

While a reverse exchange provides some additional flexibility by allowing investors to acquire the new asset before liquidating the old asset, the same strict timeframes apply. Once your exchange accommodation titleholder has taken title to the new property, you have 45 days to identify which of your real estate properties will be exchanged and 180 days to successfully close on the sale of that property.

Keep in mind that 1031 exchanges are specifically for real estate that is “held for use in a trade or business or for investment,” so a property that you currently live in would not qualify. However, if you own a property that was previously being used as your primary residence but has been converted to a rental property and is currently being used as an investment, it may qualify for a 1031 exchange when you’re ready to sell, depending on how long it has been used for investment purposes.

It’s also possible to convert a property that was purchased as part of a 1031 exchange from investment use to personal use after the fact without reversing the tax deferral benefits as long as you meet the strict safe harbor requirements specified by the IRS, which state that in each of the 12-month periods after the replacement property was purchased as part of a 1031 exchange:

The property must have been occupied by a tenant paying fair market rent for at least 14 days.

You can’t have enjoyed personal use of the property for more than 14 days, or for more than 10% of the number of days that the property was rented at fair market value, whichever is greater.

Estate Planning and "Stepped-Up Basis"

One incredibly important thing to note is that when you complete a 1031 exchange, the capital gains taxes are deferred, not eliminated. For example, let's assume that you sell a property (let's call this "Property A") as part of a 1031 exchange that otherwise would have left you with a $100,000 capital gain to pay taxes on. The provision allowed by the Internal Revenue Code essentially allows you to roll that gain over to the next property ("Property B"), and then claim the gain for tax purposes once you eventually sell. If you end up selling Property B a few years later at a gain of $50,000, you would then be responsible for paying taxes on $150,000 worth of gains ($100,000 in gain that was rolled over from Property A to Property B at the time of the 1031 exchange, plus the $50,000 in actual gain on Property B).

However, as mentioned earlier, there is no limit to how many times you can take advantage of the 1031 exchange strategy. So, if you were to do another 1031 exchange when you eventually sell Property B and purchase yet another property (Property C), you would kick the can down the road even further and continue deferring the taxes owed on your gains from both Property A and Property B until you eventually sell Property C - Unless you do yet another 1031 exchange at that point.

In theory, you could continue swapping one property for another dozens of times and rolling over the accumulated gains from each property to the next. Now, if the day comes when you sell one of these properties without doing a 1031 exchange, then you could end up with a very large tax bill - All of the accumulated gains from each property that had been deferred throughout the long chain of 1031 exchanges would now be subject to taxation.

This is where estate planning comes in. If you hold onto your last replacement property until you pass away without selling, your heirs will inherit that property on a "stepped-up basis." At that point, all of the accumulated gains that had been deferred through 1031 exchanges would truly be wiped away, and if your heirs sell the property, their capital gain would be calculated based on any growth from what the fair market value of the property was at the time they inherited it.

So, does a 1031 exchange make sense for you? The answer is, "it depends." While we've gone to great lengths to provide as much information as possible in this article, none of the information above should be construed as legal, tax, or accounting advice. Please make sure to consult with a qualified tax professional, such as a CPA, to see if a 1031 exchange makes sense for your specific situation.