What Is a 1031 Exchange?
A “1031 exchange” is how investors refer to a special provision in Section 1031 of the U.S. Internal Revenue Service’s tax code. This section states that investors may use a 1031 exchange to exchange one investment property for another to defer capital gains (or losses) that they would otherwise have to pay at time of sale.
Why Is This Important?
Why do so many real estate investors use a 1031 exchange? Because it allows investors to defer paying capital gains, super charging their ability to build wealth through real estate investing.
For example, if you buy a piece of real estate for $200,000 and then sell it for $600,000, you are subject to paying capital gains taxes on your $400,000 profit. From that $400,000, you might lose, say, $100,000 to capital gains taxes. With a 1031 exchange, you may be able to use the full $600,000 to purchase a new property (or several new properties), without paying capital gains taxes at the time of sale. This means you maximize your equity to purchase new investment properties, which may generate more cash flow and/or better appreciation. It's similar in concept to a 401K, allowing your investment principal to grow tax deferred.
What Types of Properties Qualify?
The language the IRS uses in the tax code is vague, stating that properties must be of “like-kind.” Most real estate will be "like-kind" to other real estate. For example, you may exchange a single-family home for an apartment complex, retail strip mall or even vacant land. Nevertheless, it is best to seek the assistance of a qualified 1031 exchange professional if you’re considering a 1031 exchange as there are plenty of pitfalls to be aware of.
1031 Exchange Requirements
- Timelines: Once the investor sells his or her property he or she has 45 days to identify property(s) of equal or greater value. The investor has 180 days from the day he/she sold their property to acquire the property(s) identified.
- Investment Properties Only: Both the property sold (the relinquished property) and the newly acquired property (the replacement property) must be held for investment or business purposes. Therefore, you cannot sell your primary residence and buy an investment property, nor could you sell and investment property and purchase a primary residence.
- Equal or Greater Debt and Equity: If the investor sells a property for $1 million, in which $500K was equity and $500K was debt, the investor must purchase new property(s) worth $1 million or more in total. Furthermore, the investor must use all of the equity and replace all of the debt to defer 100% of the capital gains taxes. The investor may add additional proceeds to the new purchase if he/she wishes and the investor can take on additional debt if desired as well. If the investor does not wish to use all of the sales proceeds he/she may do a partial exchange and pay the applicable capital gains taxes on the difference. This is referred to as "boot."
- Facilitation through a Qualified Intermediary: The investor must use a third-party Qualified Intermediary (QI) to facilitate the 1031 transaction. Feel free to reach out if you need a referral.
As you can see, 1031 exchanges offer immense benefits. But their execution is tricky. Plenty of caveats wait to ensnare investors. If you don’t get the whole deal right, you may end up paying taxes on the entire sale.