1031 Exchange Rules: What Real Estate Investors Must Know

Are you a high-income professional looking for ways to lower your taxes? The 1031 exchange is one of the best ways to save money on taxes, as it allows investors to sell, exchange properties, reinvest the proceeds, and avoid paying taxes on the profit until later.

You can free up money to invest in more properties by paying less in taxes. This is how the rich keep getting richer.

The 1031 exchange has been around for over 90 years and is a popular choice for real estate investors wanting to diversify their portfolios while paying less on their tax return.

It’s crucial to understand that this is NOT a way to avoid paying taxes forever. They must be eventually paid, but it does allow for postponement until a later date.

In this article, we’ll discuss what a 1031 tax-deferred exchange is, why it’s important, some pros and cons, and a couple of alternative strategies.

Whether you’re a high-income professional looking for ways to lower your taxes or a real estate investor seeking to grow your portfolio, understanding the 1031 exchange can help you make informed decisions about your investment strategy and tax planning.

*Disclaimer: I’m a periodontist, not an attorney or tax advisor. Don’t take any of this as financial or legal advice. Consult with your professional team for help with your situation.

What Is a 1031 Exchange?

A 1031 exchange, also called a like-kind exchange or Starker exchange, is a way for investors to defer paying capital gains taxes on the sale of a property until they buy a new one.

This is a useful tool for those who want to improve their rental property (i.e., apartment building, office building, etc.) because it lets them put money from the sale of one property toward the purchase of another without paying taxes on the sale.

The 1031 exchange goes back to a part of the Revenue Act of 1921 that allowed farmers to put off paying taxes on the sale of their land if they used the money to buy another farm. In 1954, this rule was changed to apply to all types of real property and has since become extremely popular.

Like-kind property

The property being sold and purchased must be like-kind properties for a 1031 exchange to be possible.

This means that they must both be real estate investments and be used for business or investment purposes in the United States. Personal property, like a car or a piece of art, doesn’t count. 

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What Are The 1031 Exchange Time Frames?

To benefit from this rule, the IRS states that a specific timeline must be followed:

Step	Action
1	Sell an investment property and buy a like-kind replacement property of the same or higher value.
2	Identify up to three potential replacement properties within 45 days of selling the initial property.
3	Purchase one or more of the identified properties within 180 days.
4	Use a qualified intermediary to assist with the exchange and handle the funds from the sale of the initial property.
5	Have the intermediary wire the capital gains to the title holder/company.
6	Complete IRS form 8824.

3 Key Dates/Deadlines of the Exchange Process

Let’s take a look at the 3 key dates/exchange deadlines necessary when completing a 1031 Exchange.

#1. The Sale Date

The investor sells their property, generally known as the sale of the relinquished property, on the sale date. The closing date signals the beginning of the time frame when the investor must find a potential replacement property.

#2. 45-Day Identification Period

Investors have a 45-day identification period after selling property they’ve given up to find a suitable replacement that satisfies the following requirements:

• The substitute property must be like-kind property to the one that was relinquished. This means that most commercial properties are comparable to other commercial properties, but a primary or personal residence and vacation homes are usually not eligible except in rare cases.
• The replacement property’s valuation, debt, and equity must match or be of greater value than those of the property that was given up. For example, if an investor sells a property for $500,000 with $250,000 in debt, the new property must have a fair market value of at least $500,000 and at least $250,000 in debt.
• Investors may designate up to three potential replacement properties, as long as they close on at least one of them or any number of replacement properties, provided the aggregate value of such assets does not exceed 200% of the value of the property being surrendered. The replacement investment properties must be legally specified, in writing, with their legal description by the Qualified Intermediary.

Due to these requirements, finding a substitute property within the 45 days can be difficult.

#3. 180-Day Exchange Period

Property owners have 180 days from the day the surrendered property was sold to close on purchasing the replacement property.

In other words, they have an additional 135 days from the time the replacement property is identified to complete the purchase. Given that it includes performing due diligence and getting financed, this time span is relatively quick.

5 Common Types of 1031 Exchanges

There are 5 types of 1031 exchanges involved in real estate transactions that investors commonly use:

• Delayed exchange in which one property is sold (relinquished) and a replacement property (or properties) is purchased within the time limit specified.
• Deferred/simultaneous exchange in which the replacement property is purchased at the same time that the present property is sold.
• Delayed reverse exchange in which the original property is purchased before the present property is sold.
• Delayed built-to-suit exchange in which the current property is replaced with a new property built to the requirements of the investor.
• Delayed/simultaneous build-to-suit exchange with the built-to-suit property purchased before the current property is sold.

During a 1031 exchange, investors can’t receive the proceeds from the sale of a property while they are locating and purchasing a replacement property. Instead, an intermediary holds these funds in escrow until the replacement property has been purchased.

The Pros and Cons of Using a 1031 Exchange

Pros of 1031 Exchanges

#1. Capital gains tax deferral

When investors use a 1031 exchange, they can defer paying capital gains taxes on selling a property. This means that the investor doesn’t have to pay taxes on the profit made from the sale. Instead, they can use the entire profit to buy another property.

Wealth can be built much faster if this process is repeated over and over again.

#2. Opportunity to invest in a portfolio

A 1031 exchange allows real estate investors to sell their properties and use the proceeds to invest in other areas of the U.S. to get exposure to new markets and better returns. There are no restrictions based on state lines.

For example, a property in Austin, TX, could be sold and exchanged for another in Baton Rouge, LA, via a 1031 exchange, avoiding taxes on the sale.

This can be helpful for investors who want to add variety to their portfolios and try new things. and pursue new opportunities.

#3. Reset depreciation

Real estate investors can write off the depreciation of their properties to offset the effects of wear and tear and aging. The IRS allows for a depreciable period of 27.5 years for residential properties (even faster using accelerated depreciation), meaning that the value of the building can be deducted from taxable income annually over 27.5 years.

But property improvements might not be fully taken into account in the depreciation calculations if the property is not reassessed when it’s sold.

A 1031 exchange offers the possibility of resetting the depreciable amount of an investment property to a higher value, providing a larger tax benefit on an annual basis. This can be a complex process, so it’s recommended that you consult with an accountant to understand how it works fully.

#4. Defer taxes until you die

A continuous 1031 exchange strategy allows investors to “swap” properties and avoid paying taxes until they die.

Once this happens, the properties can be passed on to their relatives without them having to pay the accumulated capital gains taxes.

Instead, they will inherit the properties on a “step-up” basis, meaning that they’ll inherit them at the current fair-market price.

This is an excellent strategy for people to accumulate generational wealth for their families over time.

Cons of 1031 Exchanges

#1. Capital gains are not accessible

You won’t be able to access the capital gains on the sale of your property using a 1031 exchange, as they must be added to your future investment.

For example, if you wanted to invest $200,000 made from the sale of a self-storage facility into a dividend stock, you’d lose the exchange’s protection and would have to pay taxes on the gain.

#2. The entire investment amount MUST be rolled over

Let’s continue with the previous example (self-storage facility) with an initial cost of $800,000 and a $200,000 profit.

When using a 1031 exchange, you must roll over the entire amount ($800k + $200k = $1m) and not just the capital gains amount ($200k). 

#3. Complicated structure

If more than one person is investing in a real estate project, performing a 1031 exchange could complicate.

For example, if four investors each own 25% of a short term rental and two of them want to get their money out, the other two investors must either buy them out and roll over 100% of the partnership’s initial investment and profits OR split the partnership in the title-holding company into two separate companies, one that is rolling over the funds and the other that is liquidating.

When To Consider a 1031 Exchange?

Here are a few reasons to consider a 1031 exchange:

• You’re looking to diversify your portfolio
• A property with higher returns has been identified
• To combine several properties into one or to divide a single property into several assets
• Reset the depreciation clock to zero

Remember, the whole point of utilizing a 1031 exchange versus merely selling one property and buying another is the tax deferral.

If you want to defer capital gains tax, then this method will allow you to invest more capital in the replacement property.

Depreciation and 1031 Exchanges

Understanding the full benefits of a 1031 exchange also requires understanding of depreciation.

If you want to learn more about this tax reduction strategy, check out this video:

Depreciation is the percentage of an investment property’s cost written off each year due to wear and tear.

After a property is sold, capital gains taxes are calculated using the property’s net-adjusted basis, which is the original purchase price plus capital improvements minus the depreciation.

If you sell a property for more than its depreciated value, you may be required to recoup the depreciation via depreciation recapture. This means the depreciation will be included in your taxable income from the sale of the property.

Since the amount of depreciation recaptured goes up over time, you may be motivated to do a 1031 exchange to avoid a huge increase in your taxable income that would come from depreciation recapture.

Any 1031 exchange will have to consider depreciation recapture when figuring out the value. 

Alternatives to Consider

Because the 1031 exchange time frame can be tight and some investors may not have to buy a whole property, two fractional ownership options could be used instead of a 1031 exchange.

Delaware Statutory Trust (DST)

The first is a structure known as a Delaware Statutory Trust (DST), which is a legally recognized trust set up for the purpose of business, but not necessarily in the state of Delaware. 

These investments are offered as replacement property for accredited investors seeking to defer capital gains taxes through a 1031 exchange and as straight cash investments for those wishing to diversify their real estate holdings.

Multiple investors pool their equity into a DST, and each owns a fractional share of a trust which in turn owns a property. Ownership in a DST is proportionate to the amount invested by each investor who are deemed as “beneficiaries” of the Trust.

The IRS treats DST interests as direct property ownership, thus qualifying for a 1031 exchange and other tax benefits.

Tenants In Common (TIC)

Another option is a Tenancy in Common (TIC) ownership structure. This is a legal structure in which two or more parties share ownership rights in a piece of real estate.

Each independent owner may control an equal or different percentage of the total property, and the parties are called tenants in common. This can apply to both residential and commercial property. 

Both choices (DST and TIC) may be utilized as replacement properties in a 1031 exchange in accordance with Internal revenue service (IRS) regulations and property identification laws.

Because both are administered by a professional third-party company, the main advantages of doing this are:

• speed
• flexibility
• passive income

Summary

There are three crucial dates to remember when completing a 1031 exchange.

The relinquished property’s sale date is the first. Since it starts the countdown for all subsequent deadlines in the transaction, treat this as “day 0.”

Second, investors must identify their replacement property by day 45. Identification must adhere to a set of regulations governing the cost and intended use.

The last date is day 180, when investors must complete their purchase of the identified properties.

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