A 1031 exchange allows you to defer your capital gains and depreciation recapture taxes from an investment property by exchanging it with another property. It might sound complicated, but if you follow the right steps, this tax break will help you get the most out of your real estate investments.
This guide will walk you through everything you need to know about 1031 exchanges. Read on to learn about what a 1031 tax exchange is and how you can take advantage of it.
What is a 1031 exchange transaction?
Section 1031, also called the like-kind exchange, is a provision of the Internal Revenue Code (IRC) that allows business owners and investors to defer federal taxes on exchanged real estate. This provision isn’t available to homeowners buying or selling their personal property (such as their primary residence) — it’s just for investment properties.
So, what is a 1031 exchange in real estate? In the simplest terms, it means selling one property and exchanging it for another. Section 1031 lets investors swap properties without paying a tax at the time of the exchange. That way, your capital gains can continue to grow tax-free.
You can't use a 1031 tax-deferred exchange for just any swap. There are a few rules:
- You can only exchange a like-kind property, or a property of the same type.
- You can’t receive any funds from the sale of the relinquished property. Funds have to be held by a third party and then immediately invested into the replacement property.
- You can only exchange real property, which includes land and improvements to land, natural products of land and water and air space near land. You can't exchange personal or intangible property.
- You have to designate the replacement property within 45 days and close escrow within 180 days of selling your first property.
We’ll break down these rules in more detail below. The key point is that your 1031 like-kind exchange isn’t a normal sale — it’s a quick exchange of two similar properties that does not result in a cash profit.
How does it work?
To complete a 1031 exchange, you'll need to find the tax basis, or taxable worth, of your old property, which is the original price plus any value gains and fees like closing costs. This will help you smoothly plan, manage and complete the exchange.
Note that for a 1031 exchange to work, you can’t cash out on the capital gain from selling your first investment property. The capital gain is simply rolled into the next property.
There is no limit on the number of 1031 exchanges you can make. If you follow the right steps, you can keep exchanging properties and deferring taxes until your final sale. At that point, you will pay a long-term capital gains tax of 15% or 20%. Below are the steps you need to follow to exchange your property investment without paying taxes.
Know what you want to buy or sell
The benefits of a 1031 exchange are clear: you can continue growing your capital gains without cashing them out, while still switching to a more profitable real estate investment.
That said, a 1031 exchange might not always be the right move. There are a lot of requirements, and it's not as flexible as the traditional buying and selling process.
The first step is to consider the property you want to sell and find a like-kind property that will work for the 1031 exchange. In other words, you should know what you’re selling, what you’re buying and why a 1031 exchange is the best move.
Pick a qualified intermediary
Find a qualified tax professional to facilitate your 1031 tax-deferred exchange. This process requires a third party to hold the funds from the sale of your first property and transfer them to the replacement property.
A qualified intermediary (QI) is a tax professional who facilitates the 1031 exchange and makes sure you meet the requirements. The only occasion when a QI isn’t required is when the properties are sold and bought on the same day — which is rare and can be risky, especially for an inexperienced investor. You should plan on hiring a QI for any 1031 exchange.
Fortunately, QIs work for reasonable rates and are pretty easy to find. Here are a few criteria you’ll want to look for when selecting your QI:
- A long history of facilitating 1031 exchanges
- Experience with non-traditional exchanges
- Access to qualified accounts (Segregated Qualified Trust Accounts or Segregated Qualified Escrow Accounts) to hold the exchange funds
- Comprehensive insurance coverage
Qualified intermediaries are not regulated like other investment professionals. Make sure your QI has insurance coverage and will hold your funds in an FDIC-backed account.
Once you've made your sale and completed the acquisition, the QI will transfer all necessary funds.
Inform the IRS
To successfully execute a 1031 exchange, you have to notify the IRS. You can do this by filing Form 8824 with your taxes for the year the exchange occurs. Consult your tax professional, and make sure the form is filed accurately — if the IRS thinks you didn’t meet the 1031 exchange requirements, you could end up with a hefty tax penalty.
Be sure to avoid taxable boot when you carry out your exchange. “Boot” refers to any additional value that comes with the exchange, including non-like-kind property. Any additional value will be taxed as a sale. For example, if you exchange your property for one of lower value, the reduced debt that comes with that exchange is taxable.
Taxable boot isn’t always easy to spot. Consult your QI or tax professional about any potential added value to ensure your exchange is tax-free.
Types of 1031 exchanges
There are a few common types of 1031 tax-deferred exchanges. They all follow the same basic rules but have different implications.
Keep in mind that the types of 1031 exchanges vary by state. That said, we can explain the basic rules and benefits when it comes to your federal income tax.
A delayed 1031 exchange is a standard exchange that takes up to 180 days and requires a qualified intermediary. As discussed above, it is possible to complete a 1031 exchange without a QI if the exchange happens in one day. This is called a simultaneous exchange and is much rarer today than it used to be.
Small investment firms and private investors generally opt for a delayed exchange. This gives you 45 days to designate your replacement property and 180 days to close escrow. Delayed exchanges are always facilitated by a QI, who will hold funds, complete documentation and help the process run smoothly.
A reverse 1031 tax exchange is pretty much what it sounds like: an exchange that takes place after you purchase your replacement property. To qualify for a reverse exchange, you cannot be the legal property owner of the replacement property. Instead, you must transfer the title for the new property to a third-party professional called an exchange accommodation titleholder (EAT).
Once you transfer the title, you must designate the property you want to exchange within 45 days. That property must be sold and the gains rolled over to your new investment property within 180 days.
In terms of taxes, a reverse exchange works just like a standard 1031 exchange process and allows you to maintain your tax-deferred capital gains.
Built-to-suit 1031 exchanges are also called construction or improvement exchanges. In this process, you can use the exchange funds from the original property to make improvements on the replacement property.
A built-to-suit exchange works like a delayed exchange, with funds held by a QI. The QI then facilitates funding for construction, painting, debris removal and other improvements. You must complete all improvements to the property before you receive the title.
If the improvements will take more than 180 days (which is common), the property title will transfer to an exchange accommodation titleholder. The EAT then acts on your behalf as the project manager, making payments for materials and labor. However, you can provide funds for the improvements through the EAT and give them instructions to pass on to the construction workers.
Built-to-suit exchanges are simplest when the improvement costs are fully covered by the exchange funds or paid for out of your pocket. It gets more complicated if you want to apply for a construction loan. The EAT, as the titleholder, might be named as the borrower and become liable for any missed loan payments. If you think your built-to-suit project will require a loan, talk to your EAT about navigating the loan process.
Know which rules to follow
A 1031 exchange is a great way to save money and defer taxes on your capital gains. However, to access those benefits, you have to follow the rules. Make sure your like-kind properties meet all the requirements of 1031 exchanges, and stick to the required time frame.
Most 1031 exchanges have two key deadlines: the 45-day rule and the 180-day rule. You must meet these deadlines for your 1031 exchange to remain tax-free.
As discussed above, after closing, you have to designate your replacement property within 45 days.
The countdown begins when your property is sold, and the funds are transferred to your QI. You should already have an idea of the potential replacement properties you want to exchange. Once you’ve narrowed down your choices, you have to designate them in writing to your QI.
According to the IRS, you can designate as many as three properties to meet the 45-day rule. That can give you a little more time to compare, decide on any improvements and identify taxable boot before the next deadline.
To qualify for a 1031 exchange, you have to close on your replacement property within 180 days. That’s not 180 days after you designate the property — it’s 180 days after the sale of your original property.
Tax implications for 1031 exchanges
As you can tell from our fair share in taxes survey, Americans are split on whether they think they’re paying too much in taxes. Real estate investors often feel like their tax rates are too high to get the most out of their rental properties.
That’s where the 1031 exchange comes in. If you exchange properties instead of buying and selling, you won’t have to pay taxes on each sale. That means your capital gains will continue growing, tax-free, until you finally cash them out in a final sale.
That doesn’t mean 1031 exchanges are right for every real estate investor. There are many forms of tax relief, and with tax refunds higher in 2022 than in previous years, you might not feel the need to defer taxes on your investment properties. A higher upfront profit could be more appealing, especially for a new investor. It all comes down to balancing your priorities.
If you decide to pursue a 1031 exchange, make sure you meet all the requirements, follow the right steps and report the exchange to the IRS by filing Form 8824. Otherwise, you could end up facing significant tax penalties.
1031 exchange key takeaways
A 1031 tax-deferred exchange might seem complicated, but as long as you follow the rules, it’s a great way to maximize your investment. Here are the key takeaways to keep in mind:
- There is no limit on the number of 1031 exchanges you can do.
- The investments you’re exchanging must be like-kind properties.
- Make sure you hire the right professionals: a QI for a delayed exchange and an EAT for a reverse exchange or built-to-suit exchange.
- 1031 rules and requirements vary in each state.
- You must report your 1031 exchange to the IRS to get the maximum benefit.
- Any extra value that comes from exchanging properties, called “boot," is taxable and has to be reported.