Real estate investors have to pay tax; that’s part of the process. However, investors can take advantage of IRS Section 1031, also known as a 1031 Exchange or like-kind exchange, to exchange a piece of property for another one without paying taxes on the capital gains.
What Is a 1031 Exchange?
A 1031 exchange is a tax deferment strategy that allows investors to defer paying taxes on capital gains from selling an investment property as long as they purchase another like-kind property. The program allows their assets to grow tax-deferred.
According to the IRS, Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts, and any other taxpaying entity may participate in a 1031 Exchange. Individuals can use any non-owner-occupied property in this exchange. Therefore, if you own a second property that you are considering selling, you can use this strategy to acquire another property and defer any taxes on capital gains. Investors can also change the form of their investment repeatedly without cashing out or recognizing any capital gain.
Investors are then only mandated to pay long-term capital gain taxes once they are ready to cash out. Typically, they will pay 15% – 20% depending on income on their profits from the final cash out. As of 2022, when a single taxpayer’s income from the profits falls between $41,676 and $459,750, they will pay 15%. Married couples or those filing jointly pay 15% when gains fall between $83,351 and $517,200. Any kind of taxpayer who makes more than the 15% bracket will pay 20% on their income.
How much will you have to pay? Use the 1031 Exchange Calculator
Although Section 1031 applies to the exchange of all real property, this article uses real estate-specific examples.
1031 Exchange Rules
To qualify for a 1031 exchange, you’ll need to stick to the following rules:
The properties involved in the 1031 exchange must be of like-kind. Like-kind properties are vague in their classification but essentially must be of the same nature or character, even if they differ in grade or quality. Both properties must also reside in the United States.
You can also exchange multiple properties for one property, or one property for multiple properties as long as they are all of like-kind. The following examples show the difference between like-kind and not like-kind properties.
- Trading a helicopter for an apartment building: Not like-kind
- Trading a multi-family apartment building for a single-family rental property: Like-kind
- Trading a single-family rental property for a rental vacation property: Like-kind
You can trade most property as long as it is not personal property. For example, you cannot trade the primary home you reside in for another one and claim 1031 exchange benefits.
Greater or Equal Value
To get 100% tax deferment, the IRS requires that the net market value and equity of the replacement property purchased must be the same as or greater than the relinquished property sold. For example, if an investor sells a $1 million property in San Jose with a $650,000 loan, they must buy $1 million or more of replacement property with at least a $650,000 loan to qualify.
In addition to greater or equal value, the same taxpayer must be involved in the entire process to qualify for the 1031 exchange. However, single-member limited liability corporations are accepted, meaning the single-member LLC can sell the relinquished property. Then the sole member of the SMLLC can purchase the replacement property directly under their name.
No Received Boot
Investors might use a “boot” of extra cash or property to make the value of the two properties equal. However, boots are tax liable. You cannot avoid paying taxes on this additional portion of the transactions.
It may be difficult to precisely time the deal when exchanging one property for another. Therefore, there are two rules in place relative to the timing of the transaction. You must follow both to exchange properties successfully.
The first rule states that you have a 45-day window after selling the first property to find the second. The money will go to an intermediary when you sell the first property. You have 45 days to submit a written designation of the property you wish to acquire. You can designate up to three properties as long as you close on one. Then 180-day rule, where you must close on the second property within 180 days of selling the first.
You can also complete an exchange in the reverse order, where you purchase the second property before selling the first. In this case, the timeline rules still apply. To complete the transaction in this order, you must transfer the second property to a titleholder, then identify the property you would like to exchange within 45 days and complete the transaction within 180 days.
Types of 1031 Exchanges
While every 1031 exchange involves receiving one property for another, there are four classifications of exchanges.
A delayed exchange is the most common form of a 1031 exchange, where a qualified intermediary (QI) holds the proceeds of the first sale until the second sale occurs. A QI is is an unrelated party that the investor brings on early in the process to facilitate the transaction. They have no financial stakes in the transaction besides for any compensation they may receive for their work.
This type of exchange is common as it allows the investor time to identify the second property and complete the transaction. Throughout this exchange, the investor sells their first property, and the money goes to the hired QI. At that point, an investor has 45 days to identify and designate up to three properties that they would like to acquire. They then have 180 days to close the transaction.
Less common than a delayed exchange, a simultaneous exchange occurs when an investor swaps their first property for a like-kind replacement in one action. Both properties must close on the same day and time to complete this exchange form. There are three ways to perform a simultaneous exchange, including:
- Two Party Trade/Swap: The most common form of a simultaneous exchange, where two taxpayers swap their investment properties without using a QI. While it may be challenging to find someone to trade property with, this exchange can run smoothly if all the paperwork is correct.
- Three Party Exchange: Three parties engage in this exchange without a QI, where the initial investor looks to swap property with someone who does not have any property to exchange. In this case, the second person then purchases a property from a third party and uses it to complete the exchange with the initial investor. In this scenario, the second party is considered the accommodating party, and advisers may discourage this form of interaction. It puts the accommodating party on the chain of title for a property they know little about and therefore grows exposed to additional risks.
- Two or Three Party Exchange w/ QI: two or three parties complete the exchange with the help of a QI. A QI is the only “safe harbor” in a simultaneous exchange and is typically an experienced professional who prepares documents and eliminates the risk of receipt issues. By using a QI, you can also transition this simultaneous exchange into a delayed exchange if needed.
A reverse exchange occurs when the investor first picks out the property they wish to acquire and hopes to move forward with acquiring that property before selling their initial one. This decision can be for several reasons, like not wanting the property to sell to someone else or needing to complete repairs on the initial property. The investor hires an exchange accommodation titleholder (EAT), who holds onto the title of the second property until the investor sells the initial property.
The investor has up to 45 days to identify a property they will exchange and then 180 days to close the transaction. Some banks may not award loans for reverse exchanges, so an investor may need to pay for the second home in cash.
Construction Improvement Exchange
A construction improvement exchange combines with a standard forward or reverse exchange to allow an investor to use the money from the sale of their first property to complete repairs or improvements on the second property. This exchange form follows the exact requirements and timeline as forward and reverse exchanges.
Investors must append all of the money from the sale of the relinquished property on improvements or down payment by the 180th day of the process and receive substantially the same property they identified by the 45th day. By the time they complete improvements, the second property must be equal to or greater in value than originally deeded. Additionally, the investor must finish improvements before acquiring the title back from a QI.
How to Start Your 1031 Exchange Process
If you’re thinking about participating in a 1031 Exchange, you can follow this general timeline and set of first steps.
1. Research Like-Kind Properties
In most exchanges, you will sell your property and then purchase another. Therefore, you should begin your process by conducting preliminary research about potential like-kind properties you can use for the transaction.
During this part of the process, you should also outline your objectives for the exchange. Why do you want to complete the transaction, and how would you like to go about the process?
2. Bring on a QI
If you decide to use a qualified intermediary to help with the process, you should hire them as early on in the process as possible. Bringing the QI on at the start will ensure that you complete all steps of the process completely.
When meeting with your potential QI, you will discuss your investment plan and have the opportunity to ask any questions. Many individuals across various occupations can qualify as a QI, however, you want to ensure that they have 1031 Exchange training. You may also personally decide you want to work with someone that has completed this type of exchange before.
The QI will take payment either as a flat fee or will take a percentage of the income from the sale. Make sure to discuss how you will pay your QI prior to signing an agreement.
3. Sell Your Property
If you participate in a forward exchange format, you must first sell your property to a buyer. Once a buyer expresses interest in purchasing, you will include a clause in the sales contract which states that the sale is part of a 1031 Exchange. Once you and the buyer come to an agreement, you will provide a copy of the contract to your QI, who will provide the necessary paperwork to complete the transaction.
After you sell, the funds from the transaction move to the possession of your QI, who holds onto the funds until you purchase the second property. The funds go into an escrow account, which is how you avoid paying taxes on the capital gain.
4. Identify Replacement Property
Within 45 days of the sale of your first property, you must identify a property you would like to purchase. You can identify up to three properties during this stage as long as you close on one of them. To formally identify a property, you must put it in writing. Your QI will assist you through this stage of the process.
5. Purchase an Identified Property
After identifying potential properties, you must move forward and close on one of them. You have 180 days from the date that you close on the sale of your initial property to close on the purchase of your replacement.
6. Report the Exchange
After completing all phases of the exchange, submit documentation to your accountant. Your accountant will document the process on IRS Form 8824, Like-Kind Exchanges.
Using 1031 exchanges, investors can avoid paying taxes on capital gains acquired through buying and selling. Throughout the four types of exchanges, investors have several opportunities for obtaining a replacement property after selling their initial one.
Before conducting any real estate activity, we recommend conducting further research and consulting with a professional to ensure you have all available information. Qualified intermediaries will guide you through the exchange while ensuring it runs smoothly.