What is a 1031 Exchange? Rules Real Estate Investors Need to Know.

Buying a home

A 1031 exchange is a tax-deferred exchange that allows you to exchange property and avoid paying capital-gains taxes. This mechanism has been used by the most successful real estate investors.

The typical tax burden on proceeds from the sale of an investment property can be avoided. Selling the property with a 1031 exchange can lessen your tax liability significantly.

With capital gains tax deferred indefinitely with this type of exchange, investors can deepen their real estate portfolios. Someone who owns a parcel of undeveloped land could instead become the owner of an apartment building, changing their entire approach to business and investing. A strip mall could be exchanged for a high rise. The possibilities are limitless.

What Is IRS Section 1031?

The U.S. Internal Revenue Service has permitted like-kind exchanges for a long time. Like-kind exchanges are when you exchange real property – whether it's used for business or as an investment – for another business or investment property of the same type. When you make a like-kind exchange, you don't need to recognize a gain or a loss under IRS Code Section 1031. However, if you receive other (not like-kind) property or money as part of the exchange, you need to recognize that gain. A loss cannot be recognized.

There are some common misconceptions about like-kind property. Some believe that you need to exchange your property for the same category of real estate. For example, when you have a farm, your 1031 exchange would need to be for another farm.

This is not true. If you want to sell your farm, the replacement property can be any other type of investment property – apartment buildings, a rental house, a manufacturing plant, etc. Many types of property qualify for 1031 tax deferral treatment.

Common property types such as undeveloped land, warehouses, strip malls and restaurants all qualify for 1031 exchanges. Other less common properties, such as wind turbines, underground storage or communication towers also qualify. Having so many choices is what can make the 1031 exchange a valuable option.

What Are the Rules of 1031 Exchanges?

Here are the primary 1031 exchange rules:

  • Another like-kind (of the same nature or character) investment property must be purchased.
  • Replacement property needs to be of equal or greater value.
  • All proceeds from the sale must be invested (no "boot" can be received).
  • Must be the same titleholder and taxpayer.
  • The new property must be identified within 45 days.
  • The new property must be purchased within 180 days.
  • The three-property rule lets you identify three potential properties, regardless of their market value.
  • The 200% rule enables you to identify unlimited replacement properties as long as the cumulative value is less than 200% of the value of the property sold.
  • The 95% rule says you can identify any number of replacement properties as long at the fair market value of the properties received by the end of the exchange is at least 95% of the aggregate fair market value of all the potential replacement properties identified. If the combined value is less than 95%, you'll forfeit the tax advantages of the 1031 exchange. It's a complicated rule that isn't used often.

Section 1031 only applies to exchanges of real property and not personal property or intangible property.

The Tax Cuts and Jobs Act was passed in December 2017. Before it passed, some property exchanges, like aircraft and franchise licenses, could qualify for 1031 exchanges. Now only real property or real estate can be eligible under Section 1031.

After the Tax Cuts and Jobs Act took effect, exchanges of intellectual property and intangible business assets (such as patents) no longer qualified as like-kind exchanges. In addition, other items like artwork, collectibles, vehicles, equipment and machinery were also no longer permitted, as well as stocks and bonds, partnership shares and certificates of trust.

To be considered like-kind, properties need to be of the same nature, even if they are different in grade or quality. Real properties are generally like-kind, even if they haven't been improved. Real property in the U.S. is not like-kind to real property in other countries.

This type of exchange can apply to investment property, such as rental homes.

Potentially it could apply to vacation or second homes, but for the property to qualify as replacement property in a 1031 exchange, the Exchanger needs to have owned the vacation home for at least 24 months. In addition, for each of the next two years, the Exchanger needs to rent the unit at the fair market rate for 14 days or more and restrict personal use (either 14 days or 10% of the number of days it was rented within the 12-month period).

What Are the Different Types of 1031 Exchanges?

Four different kinds of real estate exchanges can be utilized in a 1031 exchange.

Simultaneous Exchange

It used to be that the buying and selling of property must all close on the same day during a 1031 exchange, what's known as a simultaneous exchange. A delay in closing could disqualify the exchange. In that case, you would need to pay the full capital gains taxes.

Deeds can be swapped with the owner of the other investment property, or the transaction can be facilitated by a third party called a Qualified Intermediary. A Qualified Intermediary has the training and experience to handle this type of transaction, helping to prevent costly mistakes. Deferring capital gains tax makes this cost worth it.

Delayed Exchange

With a delayed exchange, you can sell your property before you buy another, allowing you to use the funding from one sale to acquire another property. Remember that a delayed exchange can't happen until you've found a buyer and executed a final purchase agreement. So, again, a Qualified Intermediary is needed to hold the sale proceeds until a like-kind property is acquired.

You'll have 45 days to find a new property and 180 days to close. It's not a tremendous amount of time, but it does give you more flexibility than a simultaneous exchange.

Reverse Exchange

You can find and purchase a new investment property before you sell your current property – this is called a reverse exchange. After that, your existing property will be traded away. This can provide an advantage in that the market value of your property increases by waiting to sell.

There are some disadvantages, as a reverse exchange is typically handled with all cash. Most banks won't provide loans for reverse exchanges. Once you purchase a new property, you have 45 days to decide which properties will be sold. After that, you will still have another 135 days to complete the sale.

Construction or Improvement Exchange

When you improve your property in advance of the exchange, it's called a construction or improvement exchange. The property is placed with a Qualified Intermediary for 180 days. During that time, you can use equity from the exchange to make improvements.

There are some requirements. You will need to spend all the exchange equity, either as a down payment or by improving the property within 180 days. The property can't be changed significantly. Once the property is returned to the taxpayer, it must be at an equal or greater value.

What About Any Leftover Money?

There may be some cash left over after the property is sold. For example, let's say you sell a property and have $1,000,000 in proceeds, and then buy a new property and only use $900,000. What happens to the $100,000 difference?

In this case, the intermediary would pay you the difference at the end of 180 days. This cash -- known as the "boot" -- will be taxed as a capital gain. "Boot" is non-like-kind property received in an exchange, in the form of cash, mortgage debt or personal property received.

Sometimes people don't consider mortgage loans or other debt on the property that's being exchanged. When your liability goes down during an exchange, that will be treated as income and taxed.

Can You Move Into a Rental Property Obtained Through an Exchange?

Suppose you'd like to use a property you acquired during an exchange as your second or even primary home. In that case, you won't be able to move in immediately.

The IRS established a "safe harbor" rule, which says they won't challenge whether a replacement home qualifies as an investment property for a 1031 exchange.

To qualify for "safe harbor," you need to:

  • Rent the unit to someone for 14 days or more.
  • Limit personal use of the unit – not more than 14 days, or 10% of the number of days during the 12 months that it's rented at fair market value.

What Are the Benefits of a 1031 Exchange?

There are a lot of reasons to consider using a 1031 exchange.

You may own property but think another property could have better prospects for a good return.

You might want to diversify your assets.

It could be that you've been managing your property but would rather own a property that someone else manages.

For purposes of estate planning, you might want to consolidate several properties into one, or conversely, you may wish to divide one large investment property into several smaller parcels.

You may want to run out the clock on the depreciation of the property. Depreciation is the cost of a property's wear and tear that is written off. Since the recapture of depreciation increases with time, you may want to use a 1031 exchange to avoid a significant increase in depreciation.

The primary benefit to using a 1031 exchange is the deferral of capital gains tax, which keeps more of your capital free for investment in the replacement property.

Because a 1031 exchange may require a high investment, this type of transaction can be best for those with high net worth. 1031 exchanges are complicated, and it's a good idea to get the help of a professional to deal with the complexities.

A Great Investment

While 1031 exchanges require quite a bit of planning and investment savvy, they can be a crucial way to build your assets. A real estate expert could help you learn about how a 1031 exchange enables you to establish an impressive investment portfolio.