Understanding How Does a 1031 Exchange Work for Real Estate

A 1031 exchange is a tax-deferred exchange that allows you to sell a property and reinvest the proceeds into a new property without paying capital gains taxes. This can be a huge relief for real estate investors who have built up a large portfolio of properties.

You can use a 1031 exchange to sell a property, known as the "relinquished property", and buy a new property, known as the "replacement property". The key is to identify the replacement property within a certain timeframe, typically 45 days.

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A 1031 exchange is a way to change the form of your investment without cashing out or recognizing a capital gain, allowing your investment to continue growing tax-deferred.

You can do a 1031 exchange as many times as you want, with no limit on frequency, and the gain from one swap can be rolled over to another, and another, and another.

A different take: Is 1031 Exchange Only for Investment Property

The IRS considers the exchange a like-kind swap, but the rules are surprisingly liberal, allowing you to exchange an apartment building for raw land, or a ranch for a strip mall.

In a typical exchange, you swap one property for another between two people or entities, but finding someone with the exact property you want can be slim.

You'll pay only one tax when you finally sell for cash, and the tax rate will be a long-term capital gains rate, currently 15% or 20%, depending on your income.

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You can exchange a wide variety of properties under the 1031 rules, including raw land, rental property, farmland, industrial buildings, residential rental property, and retail rental spaces.

Some examples of eligible exchanges include swapping one large property for three smaller properties that add up to equivalent or greater value, or exchanging property in one state for property in another state.

Here are some examples of eligible properties you can exchange:

Keep in mind that primary residences, property held primarily for sale, and personal property like artwork, aircraft, or boats do not qualify for a 1031 exchange.

Depreciable property can trigger a profit known as depreciation recapture that is taxed as ordinary income. This can happen when a depreciable property is exchanged and the depreciation you've previously claimed will be recaptured as ordinary income.

Generally, swapping one building for another building can avoid depreciation recapture. However, exchanging improved land with a building for unimproved land without a building will trigger recapture.

Depreciation is the percentage of the cost of an investment property that is written off every year due to wear and tear on the physical asset. This can increase the taxable income from the sale of the property.

A 1031 exchange can help delay depreciation recapture by rolling over the cost basis from the old property to the new one. This means your depreciation calculations continue as if you still owned the old property.

Discover more: Cost of Reverse 1031 Exchange

The like-kind requirement is a key aspect of 1031 exchanges. It means that the properties swapped must be of the same kind, but the definition is broad.

Related reading: 1031 like Kind Exchange

Properties can be swapped for other investment or business properties, regardless of their type. This includes apartment buildings, office buildings, or undeveloped land.

You don't have to exchange one property type for another of the same type. For example, you can swap an apartment building for an office building.

The key is that both the old and new properties must be used for investment or business purposes.

For another approach, see: Can You Buy Multiple Properties with a 1031 Exchange

You can name multiple replacement properties in a 1031 exchange, and the rules are quite flexible. You can identify up to three properties without regard to their fair market value, as long as you close on one of them within the 180-day time period.

The 200% rule allows you to identify unlimited replacement properties as long as their cumulative value doesn't exceed 200% of the value of the property sold. This means you have a lot of flexibility in choosing your replacement properties.

Take a look at this: What Is a 1031 Exchange Property

You can also identify as many properties as you like under the 95% rule, as long as you acquire properties valued at 95% of their total or more. However, this rule is a bit more complicated and requires careful consideration.

The key is to identify your replacement properties within the 45-day time period, and then conclude the exchange within the 180-day time period. This will ensure that your 1031 exchange is valid and you can avoid paying taxes on the gain.

Worth a look: 1031 Exchange Period

You can convert a vacation home into a rental property and still do a 1031 exchange, but you need to rent it out for at least six months or a year and conduct yourself in a businesslike way.

To qualify for a 1031 exchange, your vacation home must be held for investment purposes, which means it needs to generate an income.

If you offer the property for rent without having tenants, it won't qualify for a 1031 exchange.

See what others are reading: Can I Do a 1031 Exchange on a Second Home

If you're planning to swap one property for another, you need to understand the rules for a 1031 exchange. You can't move into the new property right away, unless you follow the safe harbor rule.

To meet the safe harbor, you must rent the dwelling unit to another person for a fair rental for 14 days or more, and your personal use of the dwelling unit cannot exceed 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

This means you'll need to find a tenant and rent out the property for at least 14 days. If you do, you'll be safe from the IRS challenging whether the replacement dwelling qualified as an investment property.

Here's a summary of the safe harbor rule:

After successfully swapping one property for another, you can't immediately convert the new property to your principal home and take advantage of the $500,000 exclusion. You'll have to wait a lot longer to use the principal residence capital gains tax break.

To qualify for a 1031 exchange, both properties must be located in the U.S. The replacement property(s) also limits you to 200% or less of the cumulative value of the property sold.

You'll need to make sure the properties are in the U.S. to qualify for a 1031 exchange. This is a straightforward requirement that's easy to meet.

The replacement property's value is also an important factor. It can't be more than 200% of the cumulative value of the property you're selling. This means you'll need to carefully consider the value of your replacement property to ensure it meets this requirement.

Here's an interesting read: How Many Properties Can You Identify in a 1031 Exchange

The proceeds from a 1031 exchange must be handled carefully, as any leftover cash will be taxable as a capital gain.

If you sell a property with a larger mortgage than the new one, the difference in liabilities will be taxed as income. For example, if you sell a property with a $1 million mortgage and buy a new one with a $900,000 mortgage, the $100,000 difference would be taxed as income.

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Depreciation recapture can also be a factor to consider in a 1031 exchange. Normally, when a property is sold, the IRS will recapture some of the depreciation deductions and factor them into the total taxable income.

A 1031 exchange can help delay this event by rolling over the cost basis from the old property to the new one, essentially continuing depreciation calculations as if you still owned the old property.

Recommended read: 1031 Exchange and Depreciation Recapture

Depreciation is the percentage of the cost of an investment property that is written off every year because of wear and tear on the physical asset.

If a property is sold for more than its depreciated value, you may have to recapture the depreciation, which means the amount of depreciation will be included in your taxable income from the sale of the property.

Depreciation recapture will be a factor to account for when calculating the value of any 1031 exchange transaction, and it's essential to understand depreciation to realize the true benefits of a 1031 exchange.

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Special rules apply when a depreciable property is exchanged, which can trigger a profit known as depreciation recapture that is taxed as ordinary income.

Typically, if you swap one building for another building, you can avoid this recapture, but if you exchange improved land with a building for unimproved land without a building, then the depreciation that you’ve previously claimed on the building will be recaptured as ordinary income.

A 1031 exchange can help to delay depreciation recapture by essentially rolling over the cost basis from the old property to the new one that is replacing it, continuing your depreciation calculations as if you still owned the old property.

Related reading: 1031 Exchange Raw Land for Rental Property

If you have cash left over after a 1031 exchange, it will be taxed as a capital gain. This is known as "boot" and can be a significant tax liability.

You must consider mortgage loans or other debt on the property you relinquish and any debt on the replacement property to avoid tax implications. Failing to do so can lead to trouble with these transactions.

Related reading: 1031 Exchange Debt Rules

A $100,000 difference in mortgage debt, for example, would be taxed as income if you sell a property with a $1 million mortgage and buy a new one with a $900,000 mortgage.

The intermediary will pay you any leftover cash at the end of the 180 days, which is considered "boot" and will be taxed as partial sales proceeds. This cash can be a significant tax burden.

If you have a larger mortgage on the old property than the new one, the difference in liabilities is treated as boot and taxed accordingly. This can result in a substantial tax liability.

Intriguing read: How to Report 1031 Exchange on Tax Return

A principal residence usually does not qualify for 1031 treatment because you live in that home and do not hold it for investment purposes.

Renting out your principal residence for a reasonable time period can change its status to an investment property, potentially making it eligible for 1031 treatment.

If you rented out your principal residence and refrained from living there, then it becomes an investment property, which might make it eligible for 1031 treatment.

You can't do a 1031 exchange on a principal residence unless you've rented it out and made it an investment property.

For more insights, see: Converting a 1031 Exchange to Primary Residence

A 1031 exchange offers several benefits, including tax deferral, which allows you to use the entire proceeds from a sale to purchase a larger property instead of paying taxes.

You can defer capital gains tax and use the extra cash towards a wider range of purchasing options, potentially accessing thousands or hundreds of thousands of dollars to invest in a larger property or receive a higher loan.

By deferring taxes, you can work with your Qualified Intermediary to acquire multiple properties in a single exchange, diversifying your portfolio and managing investment risk more efficiently.

This flexibility enables you to adjust properties based on your desired level of involvement and take advantage of new opportunities across the U.S.

You can also consolidate several properties into one, making property management easier, such as exchanging two duplexes for a retail strip center or one property in a more expensive state for three in a more affordable one.

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Here are some of the key benefits of a 1031 exchange:

By using a 1031 exchange, you can grow your wealth more quickly and open up more opportunities for investment, potentially bringing in additional income year after year by investing in more valuable and profitable properties.

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You can exchange an investment property for another without recognizing a capital gain, allowing it to continue growing tax-deferred.

You can do this multiple times, with no limit on frequency, and still avoid tax until you sell for cash many years later.

You'll pay only one tax when you sell, at a long-term capital gains rate, which is currently 15% or 20%, depending on your income.

To facilitate a 1031 exchange, you'll need to work with a qualified intermediary, who will hold the funds involved in the transaction until they can be transferred to the seller of the replacement property.

A qualified intermediary can have no other formal relationship with the parties exchanging property, and is necessary to keep the proceeds from the sale of the original property from becoming taxable.

Worth a look: Qualified Intermediary 1031 Exchange

Using a qualified intermediary is a crucial step in a 1031 exchange. They're responsible for holding the funds involved in the transaction until they can be transferred to the seller of the replacement property.

A qualified intermediary can be a person or company that agrees to facilitate the exchange by holding the funds. They can't have any other formal relationship with the parties exchanging property.

The qualified intermediary ensures that the proceeds from the sale of the property remain taxable, so they can't be held by the seller. This is why it's essential to use a qualified intermediary in the first place.

The qualified intermediary transfers the funds to the seller of the replacement property, completing the exchange. This is the key to a successful 1031 exchange.

For another approach, see: 1031 Exchange Investment Funds

A 1031 exchange can be a powerful tool for real estate investors, but it can also get complicated when partners don't agree on what to do with the property.

You can exchange one business for another, which is surprisingly liberal, but there are traps to get caught up in.

If some partners want to make a 1031 exchange and others don't, you can use a procedure called "drop and swap." This involves transferring partnership interest to the LLC in exchange for a deed to an equivalent percentage of the property.

To initiate the drop, it's desirable to do so at least a year before the swap of the asset, otherwise the partner(s) participating in the exchange may be seen by the IRS as not meeting that criterion.

If that's not possible, the exchange can take place first and the partner(s) who want to do so can exit after a reasonable interval, known as a "swap and drop."

Expand your knowledge: What Is Not Allowed in a 1031 Exchange

Timing and reporting are crucial aspects of a 1031 exchange. You have 45 days to identify potential replacement properties in writing to the qualified intermediary who is holding the proceeds from the sale of the old property.

You must complete the replacement property exchange transaction, or closing, no more than 180 days after the sale of the exchanged property. This time period runs concurrently with the identification period, so be mindful of the clock.

To receive the full benefit of a 1031 exchange, your replacement property should be of equal or greater value. You must identify a replacement property for the assets sold within 45 days and then conclude the exchange within 180 days.

There are three rules that can be applied to define identification: the three-property rule, the 200% rule, and the 95% rule. The three-property rule allows you to identify three properties as potential purchases regardless of their market value.

Here's a quick summary of the key timing rules:

You must notify the IRS of the 1031 exchange by compiling and submitting Form 8824 with your tax return in the year when the exchange occurred. The form requires you to provide descriptions of the properties exchanged, the dates when they were identified and transferred, and the value of the like-kind properties.

Discover more: Tax Form 1031

If you're planning to use a 1031 exchange for a rental property, you'll need to consider the replacement property's use, as 1031 exchanges are not allowed for properties used for personal use.

You can still use a 1031 exchange for a second home, but it must be used as an investment property for a certain amount of time before you can sell it and use the proceeds for a replacement property.

A key consideration is the 180-day timeline, which starts when you sell your relinquished property. If you're not careful, you could inadvertently trigger a taxable event.

For another approach, see: 1031 Exchange Properties Sale

Inheritance Properties can be a complex issue, especially when it comes to 1031 exchanges. Deferred capital gains taxes from 1031 exchanges are erased upon the death of the original seller.

The properties purchased using the exchange then pass on to the seller's heirs without the deferred taxes. This can be a significant advantage for heirs who inherit properties that have increased in value over time.

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The heir receives the property with a step-up in basis, which means the property is inherited with a cost basis matching its current market value. This can greatly reduce or even eliminate capital gain taxes when the property is sold.

For example, if a property is originally purchased for $500,000 and is worth $800,000 when the seller dies, the heir inherits the property with a cost basis of $800,000. If the heir sells the property immediately, they won't have to pay capital gain taxes.

Recommended read: 1031 Exchange Step up Basis

If you're planning a renovation during a 1031 exchange, be aware that certain expenses can impact the value of the transaction.

Renovation costs like repair or maintenance costs, insurance premiums, and property taxes are not eligible to be paid with exchange funds.

These expenses are considered taxable and may affect the boot calculation.

To avoid complications, it's essential to keep track of these costs separately from the exchange funds.

If you're unsure about what expenses are eligible, consult with a qualified intermediary or tax adviser to ensure compliance with IRS regulations.

Recommended read: 1031 Exchange Closing Costs

The Tax Cuts and Jobs Act of 2017 changed the rules for 1031 exchanges, limiting them to real property only, excluding personal property like franchise licenses, aircraft, and equipment.

Before the TCJA, exchanges of corporate stock or partnership interests didn't qualify, and still don't, but interests as a tenant in common in real estate still do.

The proceeds from a 1031 exchange must be handled carefully, as any cash left over after the exchange is taxable as a capital gain.

A discrepancy in debt, such as a larger mortgage on the old property than the new one, is treated as boot and taxed accordingly.

If you sell a property with a $1 million mortgage and buy a new one with a $900,000 mortgage, the $100,000 difference would be taxed as income.

You must consider mortgage loans or other debt on the property you relinquish and any debt on the replacement property to avoid trouble with these transactions.

Holding the property for several years after an exchange is advisable to avoid the IRS disqualifying the exchange.