If you’re a real estate investor and you sell a property that you’ve held for many years or that you sell at a substantial profit, a 1031 exchange can be your best friend. This is a tax strategy that allows real estate investors to essentially defer paying any taxes on the sale of an investment property for as long as they want.
While a 1031 exchange can certainly be a smart strategy to use, the reality is that they are fairly complex and it’s important for investors to learn how they work before attempting to complete one.
A 1031 exchange allows real estate investors to defer tax liability on the sale of an investment property by using the sale’s proceeds to acquire a new property. The basic idea is that if the investor didn’t actually receive any proceeds from the sale, then there isn’t any income to tax.
1031 exchanges are very popular for investors who want to upgrade to a larger investment property without taking a tax hit when selling their smaller property. It is also a popular strategy if an investor wants to sell a property located in one market and buy a property located elsewhere. However, it can be used in many different situations involving the sale of investment properties.
The taxes can be deferred indefinitely as long as no monetary benefit is ever received from the sale of a property. For example, if you complete a 1031 exchange, hold that property for several years, and then sell it and buy another property, you can continue to use this method to avoid paying taxes. In other words, if you never "cash out," you can defer taxes forever.
When you sell an investment property, there are two kinds of taxes you may have to pay.
The first is known as capital gains tax and applies if you sell any asset for more than you paid for it. For example, if you spent a total of $150,000 to acquire an investment property and sell it for net proceeds of $175,000, you have a $25,000 capital gain. If you held the property for longer than a year, it will be considered a long-term capital gain, which gets favorable tax rates. If you held the property for a year or less, you’ll pay your ordinary income tax rate on this gain.
The second type of tax is known as depreciation recapture and is designed to offset the depreciation deductions investment property owners can claim each year. For residential rental properties, depreciation is taken over a 27.5-year period, so a $200,000 property would get a $7,273 deduction each year. These add up over time, and all of the cumulative depreciation deductions you’ve taken are considered taxable income once you sell.
Here’s an example. Let’s say that you bought a duplex for $150,000 10 years ago. You just sold it for $200,000. Over your 10-year ownership period, you claimed $54,545 in depreciation. We’ll say that you’re in the 24% tax bracket for 2019.
Your long-term capital gains rate is 15%, so you’d owe $7,500 on the capital gains portion of the sale. Depreciation recapture is taxable as ordinary income, so this would add $13,091 to your tax bill. In all, you’d have to pay $20,591 in taxes on the sale of the property. That’s why a 1031 exchange can be such a valuable tool.
According to the IRS, the property or properties you acquire in a 1031 exchange must be "the same nature or character" as the property you sell.
This doesn’t necessarily mean that you need to buy the same type of property. A duplex doesn’t need to be "exchanged" for a duplex, an office property doesn’t need to be exchanged for an office property, and so on.
All this means is that you acquire a property (known as the replacement property) that you intend to hold for investment.
In other words, you can’t sell an investment property, acquire a vacation home for you and your family, and call it a 1031 exchange. You can, however, sell a single-family rental home and acquire a retail building, as long as both assets are intended as investment properties.
To be perfectly clear, there’s a difference between a property you intend to hold as an investment and a property you bought for the purpose of selling for a profit. While there are no specific guidelines when it comes to how long you need to hold a property for in order to use it in a 1031 exchange, the rule of thumb is that if you bought the property as a fix-and-flip, or you sold it shortly after you acquired it at a substantial profit, it is not likely to be a candidate for a 1031 exchange. This is one part of the 1031 exchange rules where you’re likely to run into some gray area, so be sure to consult a qualified tax professional if you’re unsure whether your property constitutes an "investment."
If you want to completely avoid taxes with a 1031 exchange, there are two conditions you need to adhere to when it comes to the amount you spend on a new property.
Combining these two rules, this means that if you sell a property for $300,000 and it has a $125,000 mortgage balance at the time of the sale, your replacement property must meet or exceed both of these numbers. A property you buy for $400,000 with a $200,000 mortgage would work. A property you buy for $400,000 in an all-cash deal wouldn’t.
With all of that in mind, a 1031 exchange isn’t an all-or-nothing transaction. There is such a thing as a partial 1031 exchange. For example, if you sell an investment property and need to use some of the sale proceeds to cover your living expenses, you can still use the rest to acquire another property and defer some of your taxes.
Here’s how this might work. Let’s say that you sell a $400,000 property on which you owe $150,000 to your mortgage company. You could take $100,000 of the sale proceeds yourself and acquire a replacement property for $300,000 and a $150,000 mortgage. The $100,000 you take from the transaction will be considered taxable income to you, and you may have to pay capital gains and depreciation recapture tax on this portion, but you can still defer the bulk of your tax liability by purchasing a lower-cost replacement property.
When completing a 1031 exchange, you can’t just sell one property and eventually acquire another. In order to complete an IRS-compliant 1031 exchange, there are two important time limits you need to keep in mind:
You’ll have 45 days from the sale of your original property to identify potential replacement properties. You can identify as many as three like-kind properties to buy, or as many as you want if the combined value doesn’t exceed 200% of the sale price of your original property. These properties must be identified in a written document and clearly described with the properties’ street addresses or legal descriptions, and this document must be delivered to your exchange facilitator (more on those later).
You have 180 days from the sale of the original property to close on the purchase of your replacement property or properties. This is when the entire exchange process needs to be completed.
Two points to clarify these rules: These timeframes refer to calendar days, not business days. And if there is more than one property involved in your 1031 exchange, the clock starts when the first property is sold.
A standard 1031 exchange is one where you sell a property, find another you like, and then close on the purchase of the other property at a later date. This is also known as a delayed 1031 exchange. However, it’s not the only type possible.
A simultaneous 1031 exchange, where you sell one property and acquire another at the exact same time, is another option. For example, if two investment property owners both want to complete 1031 exchanges, it’s entirely possible for them to simultaneously swap deeds and have it count as a 1031 exchange. Or a third-party facilitator can set up a simultaneous exchange between buyers and sellers of properties.
In addition to a simultaneous or delayed exchange, you can complete a 1031 exchange in reverse. For example, let’s say that you identify the investment property you want to buy before your original property sells.
This isn’t terribly common, but it’s perfectly legal to complete a 1031 exchange in reverse. The timeline even works in the exact opposite manner. You’ll have a maximum of 45 days from the purchase of the new property to identify which property you want to sell, and as many as 180 days from the purchase to complete the sale and finalize the exchange.
In most cases, the rules of a 1031 exchange require that the owners of the original and replacement properties be the exact same person, group of people, or company. If the original property is titled to you alone, the replacement property should be owned by you. If the original property was held in the name of an LLC, the replacement property should be owned by the same LLC.
What this means is that if you own an investment property with partners, you generally cannot sell the property and use only your portion of the proceeds to complete a 1031 exchange.
As I just mentioned, you only have 45 days from the closing of your original property’s sale to identify as many as three potential replacement properties. You don’t necessarily need to buy all of the properties you identify -- if you identify three, you can ultimately acquire one, two, or all three. This window can go by quickly, so here are some good places to start your search:
Your cost basis on real estate is simply the price you pay to acquire a property, including any acquisition costs. For example, if you pay $150,000 to acquire a property and pay $5,000 in various legal expenses and lender fees, your cost basis will be $155,000.
Over time, your cost basis can change as you make improvements to the property. Continuing our example, if you spend $10,000 on a new roof for the property, it would increase your cost basis to $165,000.
On the other hand, real estate investors can claim a depreciation expense against their rental income each year, and this adjusts the cost basis downward over time.
In a nutshell, at the time you sell a property, your adjusted basis is the acquisition cost of the property plus any capital improvements you made minus the cumulative depreciation you’ve claimed during its holding period.
With the above information in mind, when you complete a 1031 exchange, you’re essentially transferring the cost basis of your original property to your replacement property. So you’ll need to calculate your new initial cost basis a bit differently:
A 1031 exchange involves selling one property and then using the proceeds to purchase another. This may sound easy enough, but it’s important to realize that you can’t simply do this by yourself and call it a 1031 exchange.
The IRS requires you to use an impartial third party to set up the exchange for you, known as an exchange facilitator. According to the IRS, your exchange facilitator can be a qualified intermediary or a "transferee, escrow holder, trustee, or other person that holds exchange funds for you in a deferred exchange under the terms of an escrow agreement, trust agreement, or exchange agreement."
Generally speaking, you’ll want to hire a reputable and experienced qualified intermediary, or QI, to facilitate your 1031 exchange. This is a person (or company) who will ensure that the 1031 exchange is completed properly on your behalf. The simple explanation of what a qualified intermediary does is that they’ll:
A qualified intermediary cannot be your real estate agent. It also cannot be a relative or a person who is related to your real estate agent. Anyone in one of these groups is known as a disqualified person. In simple terms, a QI must not have any major conflict of interest in the transaction.
Confused yet? There’s a lot involved with completing a successful and IRS-compliant 1031 exchange. To attempt to make things a bit easier for you, here’s a consolidated list of the general steps of a standard (deferred) 1031 exchange:
In addition to the cost associated with normal real estate transactions, such as sales commissions and other closing costs, there are additional expenses involved with hiring a qualified intermediary to complete the process.
Qualified intermediaries get paid in two main ways. They generally charge a fee for facilitating the transaction -- this can vary significantly, but it’s reasonable to expect to pay between $600 and $1,200 for a standard deferred 1031 exchange. Expect these fees to be significantly higher if your exchange involves more than one property, or if you complete a non-standard (simultaneous or reverse) 1031 exchange.
In addition to the fee, qualified intermediaries typically make the bulk of their money from interest income that results from holding your money in escrow between the sale of your original property and the purchase of the replacement property. For example, if a QI is holding $500,000 for a three-month period in an account that pays 2% interest, they’ll make $2,500 in interest income. This isn’t a direct cost of a 1031 exchange, but it’s worth knowing about.
In order to complete a 1031 exchange, you’ll likely need to use the services of three qualified professionals:
The bottom line is that a 1031 exchange can be an excellent tax strategy for savvy real estate investors, but it’s not a simple process. Be sure you know the process well, and that you enlist the help of qualified and experienced professionals before you attempt to complete a 1031 exchange in your own portfolio.