If you own investment property or are considering investing in real estate, you should understand what a 1031 exchange is and how it works.
Real estate has long been a popular investment among individuals and businesses alike.
In fact, 23% of adults in the U.S. believe investing in real estate is the best way to build personal wealth, according to a recent CNBC survey. By comparison, only 16% of adults surveyed believe investing in stocks is the most effective wealth-building strategy.
Yet when it comes to investing in real estate, capital gains taxes can quickly eat away at your profits—especially if you’re successful. Thus, it’s important to understand what a 1031 exchange is, so you can avoid overpaying Uncle Sam.
What Is a 1031 Exchange?
A 1031 exchange—also known as a like-kind exchange—gets its name from Section 1031 of the U.S. Internal Revenue Code. It allows real estate investors to defer paying capital gains taxes if they sell a property and subsequently reinvest the proceeds in a qualifying like-kind property.
Since the proceeds from the sale of a property remain taxable, a qualified intermediary must facilitate a 1031 exchange. A qualified intermediary is an independent third party that holds the sale proceeds from the original property in a binding trust until the seller purchases a replacement property. The intermediary then transfers the funds to the seller of the new property to complete the exchange.
Originally, investors could use 1031 exchanges to swap other types of personal property in addition to real estate. However, the Tax Cuts and Jobs Act reduced the scope of like-kind exchanges to just real estate beginning in 2018.
Rules & Requirements
To successfully execute a 1031 exchange, a real estate investor must meet five primary requirements.
- The original and replacement properties must be a like-kind properties. Since 1031 exchanges only apply to real estate, an investor can exchange nearly any type of property for another, so long as they’re both located in the United States. You can also exchange one larger property for several smaller properties, although additional rules apply.
- The exchange must involve investment or business properties only. In other words, primary residences don’t qualify for 1031 exchanges.
- The replacement property must be of greater or equal value to the original property. You can do a partial exchange, but you must pay capital gains taxes on the difference in value (i.e., the “boot”).
- The names on the tax returns and titles of both properties must be the same. An exception to this rule is if you use a single-member LLC to sell the original property and purchase the replacement property in your own name.
- You must adhere to the exchange time limits. An investor generally has 45 days from the sale of the original property to identify a replacement property and 180 days from the sale date to close on the exchange.
Types of 1031 Exchanges
In general, there are four main types of 1031 exchanges:
- A delayed or deferred 1031 exchange is the most common type of like-kind exchange. With this type of exchange, an investor has up to 45 days from the sale of their original property to identify a replacement property and up to 180 days from the sale date to complete the transaction. Failing to adhere to these time frames can disqualify the 1031 exchange.
- A reverse or forward exchange is essentially the opposite of a delayed exchange and thus more challenging to execute. With this type of exchange, an investor buys a replacement property first and sells the original property afterwards. The investor must use all cash to fund the new purchase and close on the sale of the original property within 180 days.
- A simultaneous 1031 exchange requires an investor to close on the sale of the original property and purchase of the replacement property on the same day and time. Even a slight delay can disqualify the exchange.
- A construction or improvement exchange allows an investor to use the sale proceeds from the original property to make improvements on the replacement property. A qualified intermediary holds the deed of the property in the meantime, up to 180 days.
1031 Exchange Benefits
Indeed, there are several potential benefits of doing a 1031 exchange, the primary benefit being the deferment of capital gains taxes when you sell an investment property. By deferring this tax, you can potentially afford to invest in a more valuable property since you have more cash on hand for a down payment.
In addition, a 1031 exchange allows you to diversify your investment portfolio and expand into new real estate markets. Meanwhile, it removes some of the headwinds associated with selling an investment property you no longer wish to manage and upgrading to better investment.
A like-kind exchange can also be a valuable estate planning strategy. If an investor purchases an investment property through a 1031 exchange and passes it on to an heir upon their death, the heir is exempt from paying the deferred capital gains taxes.
Lastly, depreciation recapture is a key benefit of 1031 exchanges. In real estate, depreciation reflects the amount of wear and tear on a property. When you sell an investment property for more than its depreciated value, you may have to recapture the depreciation, which increases your taxable income. A like-kind exchange helps you avoid this increase in taxable income post-sale, thus lowering your overall tax bill.
While 1031 exchanges have many potential benefits, they also have their drawbacks.
First, they lock up your capital since you must keep rolling it from one investment property to the next. This can be problematic if you need access to cash and have no other liquidity sources, or if you want to invest in something other than real estate.
In addition, 1031 exchanges have a tight timeline, which can make it difficult to find a suitable replacement property. Moreover, any delays in timing can disqualify the exchange altogether.
Finally, like-kind exchanges can be challenging if you’re part of a partnership group. To execute a 1031 exchange, all members must agree to sell and approve the replacement property within a tight time frame. On the other hand, if one or more partners wants to withdraw their capital after selling an investment property, the remaining partners must buy them out or legally separate the partnership.
When to Consider a 1031 Exchange
If you invest in real estate, there are a variety of reasons to consider a 1031 exchange. Typically, the primary reason is to defer paying federal income taxes—especially in high-tax-bracket years.
In addition, you may consider a like-kind exchange if you’re looking to upgrade an existing investment property. Perhaps you don’t like the location, or the property has become too difficult to manage.
A 1031 exchange allows you to invest in a potentially more valuable property than you could otherwise since capital gains taxes aren’t eroding your profits. Alternatively, you may want to exchange one property for several smaller properties to diversify your risk and improve your return potential.
Lastly, you might consider a like-kind exchange during the estate planning process. For example, you may want to consolidate several properties into one, so you only have one real estate asset to transfer upon your death. And since the property value is stepped up to fair market value when your heirs inherit it, they don’t have to pay taxes on it.
Milestone Asset Management Group Can Help
A 1031 exchange can be valuable tax planning tool if you invest in real estate. Yet they can also be complicated to execute. Indeed, failing to meet the rules and requirements can disqualify the exchange and potentially trigger a large tax liability.
A financial planner like Milestone Asset Management Group can help you determine whether a like-kind exchange makes sense for you. Our in-house team of CPAs and estate planning attorneys can also help you identify additional strategies to potentially reduce your overall tax bill.
To speak with a member of our team about our services and your financial planning needs, please schedule an introductory phone call. We look forward to hearing from you!