1031 Exchange: Everything You Need To Know

Here’s Everything You Need To Know About A 1031 Exchange

• What is a 1031 Exchange?
• Advantages of a 1031 Exchange
• 1031 Exchange requirements
• How to complete a 1031 Exchange
• 1031 Exchange 5 year rule
• Risks and limitations of a 1031 Exchange
• What is a 1031 Reverse Exchange?

The 1031 Exchange: A Tax Shield For Real Estate Investors

Real estate investing is a tremendous way to build wealth and make money on the side, but new investors often neglect the web of tax complications that go along with real estate investing, and that have a huge effect on returns. 

But not all complications are bad - there are many, many tools in the arsenal of seasoned real estate investors to maximize their investment while minimizing their tax exposure.

A 1031 exchange is one of these tools. It lets investors put off paying capital gains taxes on the sale of an investment property by putting the money from the sale into a new property. In this post we'll break down what a 1031 exchange is, how it works, and why it's a useful tool for real estate investors who want to maximize wealth by paying less in taxes.

What Is A 1031 Exchange?

A 1031 exchange is a tax-deferred exchange that lets real estate investors sell one investment property and use the money from that sale to buy another property without paying capital gains taxes on the first sale. The exchange is named after Section 1031 of the Internal Revenue Code, which explains the rules and requirements for this kind of transaction.

Both the property being sold and the property being bought must be "like-kind" properties for a 1031 exchange to be possible. This means that the two properties must be the same, even if they are in different places or have different qualities or other differences. For example, you can trade a residential rental property for a commercial office building or a vacant lot for an apartment complex.

More on that in a bit.

Advantages Of A 1031 Exchange

• Capital Gains Tax Deferrals: One of the best things about a 1031 exchange is that it lets you put off paying capital gains taxes when you sell an investment property. This can help investors get the most out of their investments by utilizing those savings as more capital to put into buying more properties.
• Improved Cash Flow: By putting money from the sale of one property into the purchase of another, investors can increase their cash flow through the rent or other investment returns on that second property.
• Investment Diversification: A 1031 exchange allows investors to purchase more properties in more areas, which can help them spread out their investments.
• Greater Flexibility: Because a 1031 exchange lets investors put off paying capital gains taxes, they have more freedom to sell properties and buy new ones without being tied down by tax bills or red tape.
• Long Term Returns: By putting off paying taxes and putting the money into new properties, investors can build a more diverse and profitable real estate portfolio that increases their prospects for long-term wealth.

1031 Exchange Requirements

• Properties Must Be “Like-Kind”: The properties involved in the 1031 exchange must be of the same asset class, even if they are in different places, have different qualities, or are different in some other way. This means, if you’re selling a residential property, you must use the savings from that sale to put towards another residential property (in this scenario, investors could make the case that buying a multi-family home is like-kind, but they couldn’t use these savings to purchase, for instance, an industrial property).
• Properties Must Be An Investment Or Be For Business: Both the property that is being sold and the property that is being purchased must be used for business or investment. Personal homes and other properties that are mostly for personal use (i.e. - you’re going to live in it) are not eligible.
• 1031 Exchange Timeline: Once the first property is sold, the investor has 45 days to find possible replacement properties and 180 days to buy the replacement property.
• Must Transact Through Qualified Intermediary: A qualified intermediary (QI) must be used to facilitate the sale of the first property and purchase of the second. The QI will keep the money from the sale of the first property and use it to buy the new property. This way, the investor doesn't get to keep the money and cause a taxable event.
• Proceeds Must Be Reinvested: To avoid paying capital gains taxes, the investor must put all of the money from the sale of the first property into the purchase of the second property. If there are any extra funds, they will be taxed as capital gains.
• No Extra Cash On The Side: In the exchange, the investor can't get any cash or other things. All of the money from the sale must be put into the new property.

How To Complete A 1031 Exchange

1. Sell The First Property: Once the original property sells, you’ll need to sign a contract that states you’re going to use these savings to purchase a like-kind property.
2. ID Potential Properties To Purchase: You’ll need to find possible replacement properties within 45 days of selling your initial property. The IRS has strict rules in place on how to report these properties; this is something your Qualified Intermediary will help you with.
3. Put The Replacement Property Under Contract: Once you’ve found a replacement property, you’ll need to put it under contract.
4. Work With Your Qualified Intermediary: For the exchange to go through, all money must move between your qualified intermediary (QI) of choice. The QI will keep the money from the sale of the first property and put it toward purchasing the second one.
5. Complete The Purchase: You have 180 days after selling your original property to buy your replacement property. These 180 include the time it takes to close on the property and change the title name.
6. File Form 8824: You need to use Form 8824 to disclose all details of the transactions to the IRS. This form must be included with your tax return for the year in which the exchange took place.

1031 Exchange 5 Year Rule

For a property to be eligible for a 1031 exchange, the investor must own the new property for at least 5 years. If the investor sells the replacement property within 5 years of purchasing it, they may have to pay back any taxes that were put off from the first exchange PLUS the capital gains tax on the of the new property.

Risks and Limitations Of A 1031 Exchange

• Strict Requirements: For a 1031 exchange to be eligible for tax deferral, it has to follow the strict requirements noted above. If any of these conditions aren't met, the investor may end up paying the capital gains taxes they worked so hard to avoid.
• Timeline: In a 1031 exchange, there are strict time limits, such as the 45-day window to identify potential properties and the 180-day period to finalize the purchase of the second property. Investors must complete the exchange within these time limits or they could lose the benefits of the 1031 exchange.
• Replacement Property Risks: Buying a new property also has a certain level of risk, and this rings true for a 1031 exchange as well.
• Potentially Limited Replacement Properties: Depending on the area, investors may be limited on their choices for replacement properties, which could force them to settle for a less-than-ideal replacement properties.
• Future Tax Rates: While investors can put off paying capital gains taxes at the current tax rate, they will have to pay them when they sell the new property. And if capital gains taxes are higher when they sell their property? They’re out of luck.
• No Guaranteed Profits: Just because it’s a 1031 exchange doesn't mean you’ll see a return on your investment. While saving on capital gains tax in the present is great, you still need to make smart fundamental investing decisions.

What Is A 1031 Reverse Exchange?

A reverse 1031 exchange is very similar to a traditional 1031 exchange, except instead of using the profits from selling the initial property to purchase the subsequent property, the investor uses a loan or other financing vehicle.

In a reverse exchange, the investor works with a qualified intermediary (QI) to buy a new property with money from a loan or another source of financing - not the sale of the original property (this would be a standard 1031 exchange). The QI keeps the replacement property until the investor can sell their old property. Once that happens, the exchange is over, and the QI gives the investor ownership of the new property.

A reverse 1031 exchange is good for when investors find a fantastic replacement property but need to move quickly before it sells to someone else. But, reverse exchanges can be more complicated and come with more risks, like possible tax consequences and the need for more financing.


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