For decades, savvy real estate investors have used Section 1031 of the IRA Tax Code to sell properties and reinvest the profits into new assets, essentially tax-free.
A 1031 Exchange defers capital gains taxes and tax penalties on depreciation recapture.
While using the 1031 Exchange is a fantastic long-term wealth-building strategy, it does have its challenges.
We’re providing you with a 1031 Exchange overview, giving you the information you need to use the 1031 Exchange to your advantage.
Disclaimer: While we have done our best to provide accurate information, this article should not replace the advice of a licensed tax attorney. Consult a professional before entering into a 1031 Exchange.
What is a 1031 Exchange?
At its core, the 1031 Exchange is an IRS Tax Code that helps investors sell existing properties and roll those profits into new assets without paying capital gains taxes or depreciation recapture taxes.
In other words, the 1031 Exchange allows real estate investors to build long-term wealth without tax penalties.
The law encourages reinvestments by allowing property owners to sell real estate and put the profits into an approved intermediary account.
Then, investors can identify and enter into a contract on a replacement property, using funds from the original sale towards the new asset, without paying capital gains taxes on that income.
History of the 1031 Exchange
The idea of a tax-free, like-kind real estate exchange dates back to 1921.
That year, Congress enacted the like-kind exchange statute, or the Revenue Act, designed to protect investors from unfair taxation and encourage continued investments in real estate.
In 1954, Congress updated the Revenue Act, adding an Amendment called Section 1031 of the IRS Tax Code, establishing much of the structure for today’s tax-deferred real estate exchanges.
More recent changes, adopted into law in 1991, clearly defined the terms of such a transaction.
In 2018, Congress passed the Tax Cuts and Jobs Act, adding new provisions to 1031 Exchanges.
For decades, real estate investors have used 1031 Exchanges to build wealth while avoiding capital gains taxes on their profits.
How the 1031 Exchange Works
Let’s say you have a real estate asset—either residential or commercial—that isn’t producing much monthly income.
If the property has appreciated, you can sell it for a profit, and use that money to reinvest in another asset.
However, if you transfer those profits into a personal or business account, you will have to pay capital gains taxes, and you will be responsible for any taxes owed on the depreciation recapture.
Depending on your tax liability, you may be liable for tens or hundreds of thousands of dollars in taxes.
This is where the 1031 Exchange comes in: With this method, you’ll set up a 1031 Exchange when you sell your property.
- At closing, the profits go to an intermediary’s account, typically a law office, title company, or other qualified intermediary that is not acting as your agent. These funds remain in escrow until you close on a new property or once 180 days have elapsed.
After the sale of an existing property, you will have 45 calendar days to identify a new asset that you will purchase using the 1031 Exchange.
These funds must be used to buy “like-kind real estate” of equal or higher value.
What are “like-kind” properties?
Like-kind properties are two assets that are the same type, are rental properties or properties used for business, and both must be within the United States under the 1031 Tax Code.
For instance, a multifamily building could be sold to purchase an apartment building. Or a warehouse could be sold to buy an office complex.
As long as both properties are investment properties and will be used as rentals or for business, and the replacement property is valued the same or higher than the relinquished property, you can use a 1031 Exchange.
Also, under the Tax Cuts and Jobs Act of 2018, only real property is eligible for a 1031 Exchange.
Personal property and intangible property, such as artwork, machinery, or intellectual property, does not qualify. However, land or anything built on the land is eligible for a 1031 Exchange.
What Properties Qualify for a 1031 Exchange?
The 2018 changes to the 1031 Tax Code limit exchanges to “real properties.”
Any real property used as a rental or investment property, or for business activities, is eligible for a 1031 Exchange.
However, short-term holdings and renovated properties purchased solely for resale are not eligible. You may not use a 1031 Exchange for primary residences.
You can also use a 1031 Exchange to purchase more than one replacement property. For instance, if you sell a medical building for $1 million, the sum of all replacement properties must be equal to or greater than that amount.
Therefore, you might choose to purchase an office building at $650,000 and a multifamily complex for $400,000.
Since those two properties together are valued higher than the relinquished property, you can use a 1031 Exchange to purchase them.
Likewise, you could liquidate several smaller properties and use the profits to buy a more substantial asset. For instance, you could sell several duplex units and, using a 1031 exchange, purchase an apartment complex.
Properties eligible for 1031 Exchanges include, but are not limited to:
- Single-family homes used as a rental property
- Multi-family residences (duplexes, townhomes, or apartment buildings)
- Vacant land
- Retail buildings
- Office space
- Industrial properties or warehouses
- Self-storage facilities
Steps to Carry Out a 1031 Exchange
1. Identify a Replacement Property
While every investor has a slightly different process, remember that you must identify a replacement property within 45 days of selling your relinquished property.
Therefore, many investors identify an income-producing property before listing an available asset.
If you fail to identify a property within 45 days or fail to close within 180 days, you will have to pay capital gains taxes on the profit from your relinquished property.
The 45-day rule presents a challenge for some investors.
With such a limited window of time, investors may feel pressured or rushed, and sometimes purchase properties they wouldn’t otherwise consider.
By identifying properties before listing your existing property, you can do your homework and avoid a hair-trigger reaction.
You can search for available commercial and multifamily properties on several well-known listings websites.
Reonomy property intelligence also allows you to identify lucrative investment properties off-market and get in direct contact with property owners.
Identifying off-market properties with Reonomy allows investors to connect directly with property owners, negotiate more favorable deals, and eliminate the price gouging caused by steep competition.
2. Identify a 1031 Exchange Intermediary
Before listing your current property or negotiating a deal on a replacement property, you’ll need to identify a 1031 Exchange Intermediary.
Your title company or mortgage broker may have recommendations for a third-party intermediary.
The 1031 Tax Code states that the intermediary cannot be your agent.
Therefore, your personal CPA, tax attorney, or real estate agent can’t act as an intermediary for a 1031 Exchange. They can, however, help you find someone who knows the process.
Essentially, a 1031 Exchange Intermediary holds the profits from the relinquished property in escrow.
Then, once you’ve identified the replacement property, the intermediary will purchase the replacement property, complete the necessary paperwork and ensure everything falls within the IRS’s guidelines.
The intermediary will then transfer the deed to you.
3. Close on the Replacement Property Within 180 Days
After establishing an intermediary, you can proceed with the purchase of a replacement property.
You must identify a replacement property within 45 calendar days and close within 180 days.
After 180 days, the law requires the intermediary to return all funds to you, and you will be responsible for paying all taxes on those funds.
The Benefits of a 1031 Exchange
Why consider a 1031 Exchange?
If you are currently holding investment properties that are vacant or aren’t producing monthly income, you can liquidate those properties and invest in something that will generate more significant wealth.
Using a 1031 Exchange, you can invest the profits from your relinquished properties without paying tax penalties.
Of course, if you ever decide to liquidate all your assets, and you don’t use those profits to purchase another real estate property, you will have to pay taxes on those gains.
That’s why most investors use 1031 Exchanges as a long-term wealth-building strategy.
It’s all about “legacy wealth.” If you continue to defer taxes on those properties using a 1031 Exchange, rolling the profits from one sale into bigger and better investments, you will avoid paying taxes over the course of your lifetime.
When you pass away, those who inherit your wealth will not have to pay capital gains taxes on inherited properties.
Therefore, you have created wealth not only by generating monthly income over the course of your life but by leaving tax-free investments to the next generation.