What is a 1031 real estate exchange: A complete guide

Did you know that by utilizing a 1031 exchange, you – as a real estate investor – can defer taxes, increase your investment capacity, and diversify your portfolio? And, improve your overall financial strategy? So, what is a 1031 real estate exchange, exactly? And, how can you qualify for it? Here’s everything you need to know if you’re considering a 1031 exchange.

What is a 1031 real estate exchange?

A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows real estate investors to defer capital gains taxes when they sell a property and reinvest the sale proceeds into a new property of like kind.

This means there is no gain or loss for tax purposes if the properties are for business or real estate investment purposes. This exchange is popular among real estate professionals.

However, the process is complex. It requires a proper understanding of the rules, such as the requirement for like-kind properties and limitations on vacation properties. There are also specific tax implications and time frames to consider. 

What are the tax implications of a 1031 exchange?

In a 1031 real estate exchange, there are several tax implications to consider. For instance, you may have to pay capital gains tax on “boot” or any leftover cash received from the exchange. That is to say, if the replacement property has a lower mortgage than the relinquished property, this boot is taxable. Additionally, if the exchange is unsuccessful, you will be taxed on the sale of the relinquished property. Over time, multiple 1031 exchanges can accumulate significant deferred capital gains, which can lead to a higher tax liability in the future.

Which type of properties qualify for a 1031 real estate exchange?

To qualify for a 1031 exchange, the properties must be of “like-kind,” a term that broadly covers most real estate. This means you can exchange different types of properties, such as an apartment building for raw land or a ranch for a strip mall. 

Of course, the 1031 exchange applies to investment and business properties under certain conditions. 

The key points to remember are:

• The real property should be like-kind.
• U.S. property can be exchanged for other U.S. property, but not for foreign property.
• Properties outside the U.S. can only be exchanged for other international properties.

Why should you do a 1031 exchange?

There are several scenarios where a 1031 exchange can be advantageous. For instance, it allows investors to increase their return on investment by swapping their current property for one with better returns. Additionally, it enables the consolidation of multiple properties into one, possibly for a life estate, offering simplified management. 

For rental properties, a 1031 exchange provides the opportunity to reset depreciation, potentially reducing tax burdens. Moreover, individuals can convert a vacation home into a rental property, generating income before exchanging it for another rental property. Lastly, investors can diversify their portfolio by selling one investment property to invest in others, with the flexibility to acquire up to three properties without limitation. Remember that guidance from a qualified intermediary (QI) is essential for navigating financing rules for further acquisitions.

Read more: The importance of escrow accounts

What are the types of 1031 exchanges?

1031 exchange process can work in three different ways.

• Delayed exchange: This is the most common type, allowing investors to sell their property and purchase a replacement within 180 days. The proceeds from the sale are held by a QI until the replacement property is bought.
• Reverse exchange: In this type, you purchase the replacement property before selling the original one. This is useful in a competitive market where quick action is needed. The replacement property is temporarily held by an exchange accommodation titleholder (EAT) until the original property is sold.
• Build-to-suit exchange or construction exchange or improvement exchange: This type of exchange lets investors use deferred tax dollars from selling their property to pay for renovations or improvements on the replacement property. The condition is that these renovations must be finished within 180 days.

What are the timelines for 1031 exchanges?

To complete a Section 1031 tax deferred exchange of like-kind properties and avoid taxable gain, you must meet two strict time limits. You must identify the replacement properties within 45 days of selling your property. Keep in mind that the property identification must be in writing. And, it should be signed by you, and delivered to a person involved in the exchange, like the seller of the replacement property or the QI. 

Remember that just notifying your real estate attorney, real estate agent, or accountant is not sufficient. 

Replacement properties must be clearly described with a legal description, street address, or distinguishable name, following IRS guidelines for the maximum number and value of properties. 

Second, you must receive the replacement property and complete the exchange within 180 days after the sale of the original property. Or, when your tax return is due for the year of the sale, whichever is earlier. 

In a reverse exchange, you can purchase the replacement property before selling the original one and still qualify for a 1031 exchange. To do this, the new property must be transferred to an EAT. You then have 45 days to identify the property to be exchanged and 180 days to complete the entire transaction from the date of acquiring the replacement property.

How to do a 1031 exchange?

To execute a 1031 exchange, you need to follow these steps:

• Identify the properties: Decide which property you want to sell and which one you want to buy. Both properties must be “like-kind,” meaning they should be similar types of investments.
• Choose a reliable QI: Work with a qualified intermediary or exchange facilitator. They will handle selling your investment property, purchasing the replacement asset, and transferring the deed to you.
• Notify the IRS: Report the exchange to the IRS by filing Form 8824 with your tax return. This form details the properties involved, the timeline, the parties involved, and the financial aspects of the exchange. Be thorough in documenting the transaction to ensure compliance with IRS regulations.

Key takeaway

A 1031 exchange allows real estate investors to defer capital gains tax by selling a property held for business or investment purposes. They can use the proceeds to purchase a new, like-kind property for the same purpose. The proceeds must be held in escrow by a third party and cannot be received by the seller at any point. When executed correctly, there is no limit to how often investors can perform 1031 exchanges. In some specific conditions, the rules can also apply to a former principal residence.

Written by Ramona Sinha. May 25, 2024

Ramona is the Senior Content Writer for Kukun. This experienced blogger uses simple and succinct words to decipher the complex phenomenon called life. She has written articles covering a broad range of topics, such as real estate, lending and mortgage, finance, business, taxation, home designs, home improvement projects, decor concepts, and more. An avid traveler, she’s a digital nomad at heart and an animal lover from the depth of her soul.