How a 1031 Exchange Works

Investing in real estate can offer a hedge against inflation while helping you create a diversified portfolio. If at some point you decide you want to shift your real estate investment dollars, you may consider a 1031 exchange. This type of exchange allows you to defer paying capital gains tax on the sale of an investment property when the proceeds are used to buy another similar property in a qualifying exchange. A 1031 exchange can be a useful tax planning tool, but there are certain rules you need to know to make sure you’re approaching it the right way.

For further hands-on guidance, consider working with a financial advisor.

What Is a 1031 Exchange?

The 1031 exchange allows you to sell an investment property and use the proceeds to invest in another property without paying capital gains immediately. Section 1031 of the Internal Revenue Code specifies what constitutes a 1031 exchange:

“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”

If you use the 1031 exchange, you don’t have to report capital gains and the related federal income tax, provided the transaction meets the requirements for full deferral. The exchange must still be reported to the IRS, generally on Form 8824. Previously, you could use 1031 exchanges for investments other than real estate, such as machinery or business equipment, collectibles, artwork or patents. The Tax Cuts and Jobs Act, however, changed the 1031 exchange guidelines so they’re now limited to real property only.

How a 1031 Exchange Works

The mechanics of a 1031 exchange are relatively simple. If you own an investment property that you’re able to sell for a profit, you could use the proceeds to buy another investment property. If the transaction qualifies for full deferral, no federal income tax would be due on the gain at the time of the exchange.

The key thing to note about a 1031 exchange is that the IRS is very specific about what you can and can’t exchange. Only like-kind property exchanges are allowed, which for IRS purposes means properties that are “of the same nature or character, even if they differ in grade or quality.”

According to the IRS, a like-kind exchange can happen regardless of whether a property has undergone improvements or not. To qualify, both properties must meet the IRS requirements for like-kind real estate. ¹ For example, if you own a duplex or apartment building and exchange it for another duplex or apartment building, that’s a like-kind exchange. However, like-kind treatment for qualifying real estate is broad enough that an apartment building may also be exchanged for certain other investment real estate, such as vacant land.

But you wouldn’t be able to use a 1031 exchange to sell a property you own in the U.S. and buy property in Canada on a tax-deferred basis. Here are some other assets that can’t be used in a 1031 exchange: property bought for resale; land held primarily for sale rather than investment; a personal residence; and generally, a home bought to be fixed and “flipped”. There is no limit to how many times you can do a 1031 exchange.

Facilitating a 1031 Exchange

Aside from following the like-kind rule, 1031 exchanges also have to go through the proper channels. That means having an exchange facilitator to help throughout the process. For a typical deferred exchange, taxpayers generally use a qualified intermediary so they do not receive or control the sale proceeds before purchasing the replacement property. Direct exchanges of qualifying real estate can occur without an intermediary.

Exchange funds can be held by a qualified intermediary or through an arrangement such as a qualified escrow account or qualified trust that meets IRS requirements. ² If you’re working with a qualified intermediary, that person must satisfy the IRS independence requirements. Certain people who have acted as your agent during the preceding two years, including your real estate broker or agent, generally cannot serve as your qualified intermediary. Family members and certain related parties are also disqualified.

It’s the intermediary’s job to oversee the sale of your old property and the purchase of a new one, holding the proceeds of the sale in escrow in the meantime. The intermediary or facilitator can also help document the exchange, which the taxpayer must report to the IRS. It’s also worth pointing out that the facilitator is paid a fee for his or her services.

Other fees to be aware of include:

• Commission fees paid to the broker
• Filing fees
• Attorney’s fees
• Title insurance
• Finder fees
• Escrow costs

These costs can be paid using funds from the exchange. However, whether an expense can be paid without triggering taxable proceeds depends on its nature. Certain selling and exchange expenses may be paid from exchange funds, while payments for property taxes, insurance premiums, repairs or other non-exchange costs can create taxable consequences.

Keep in mind also that all of this has a timeline that must be followed. The IRS allows you 45 days to identify a potential replacement property after the sale. The replacement property must generally be received by the earlier of 180 days after transferring the relinquished property or the due date of the tax return for that year, including extensions.

Benefits of a 1031 Exchange

The main advantage of a 1031 exchange is the opportunity to defer paying taxes on capital gains associated with the sale of an investment property.

A 1031 exchange can also be useful in building out a portfolio of multiple investment properties. For example, it’s possible to exchange one property asset for multiple properties or vice versa, exchanging several properties for a single real estate investment. You can use a 1031 exchange to tailor your property investments to fit your needs and goals.

It’s possible to trade up or down while enjoying more flexibility than you might with other real estate investments. For instance, with real estate crowdfunding or real estate investment trusts (REIT), you generally have very little flexibility in terms of timing your exit. And REITs can lack transparency when it comes to the underlying investments.

Using 1031 exchanges to manage investment properties means you can choose when to time your exit from one property and entry into another. And as your properties appreciate, you can benefit from an increase in your equity in those holdings.

One important thing to keep in mind, though, is that you may still owe taxes on a 1031 exchange if you’re receiving a cash benefit from the transaction. For instance, if you sell a property that has a $1 million mortgage and buy a new one that only has a $750,000 mortgage, the $250,000 reduction in debt could be treated as money received in the exchange. However, additional cash contributed or other liabilities assumed may offset that amount. Any taxable gain is limited by the gain realized on the exchange and the applicable rules for money or other non-like-kind property received.

How Cash Received Affects Taxes in a 1031 Exchange

Receiving cash from a 1031 exchange can result in an immediate tax obligation even when the rest of the transaction qualifies for deferral. The IRS generally treats cash and certain other non-like-kind property received in an exchange as taxable proceeds, commonly called boot.

Consider an investor who owns a rental property with an adjusted tax basis of $200,000 and sells it for $400,000. Assume there are no mortgages or transaction expenses. The investor uses a qualified intermediary to complete the exchange.

The investor purchases a replacement rental property for $350,000 and receives the remaining $50,000 in cash.

In this scenario, the investor recognizes $50,000 of gain in the year of the exchange and postpones recognition of the remaining $150,000. The replacement property’s adjusted basis would generally be $200,000, calculated as the original $200,000 basis minus the $50,000 cash received plus the $50,000 recognized gain.

The recognized gain is not necessarily taxed entirely at long-term capital gains rates. Depreciation history, Section 1231 rules and other tax circumstances may affect its treatment. The exchange must also be reported on IRS Form 8824.

Rules for Exchanging Depreciable Property

If you are using the 1031 exchange with a depreciable property, then there are certain rules that you need to be aware of. This type of activity can trigger something known as depreciation recapture, which is the treatment of certain gains attributable to previous depreciation deductions. Depending on the property and applicable tax rules, the gain may be taxed as ordinary income or receive special capital gains treatment.

You may be able to defer recognizing depreciation-related gain when you exchange qualifying property for replacement real estate. However, receiving cash or other non-like-kind property can cause some gain to become taxable. Different types of depreciable property may also be subject to different recapture provisions.

For example, a rental building depreciated using the straight-line method generally does not produce ordinary-income recapture under Section 1250 solely because of those deductions. Instead, gain attributable to depreciation may be classified as unrecaptured Section 1250 gain, which has a maximum federal tax rate of 25%.

When this is triggered, you may have to recognize part of the gain associated with depreciation previously claimed on the original property. A qualifying exchange can defer some or all of that gain, depending on the transaction. This can be a complicated part of 1031 exchanges, so it’s important to consider consulting with a financial advisor to help you with any transactions.

Bottom Line

A 1031 exchange could help you minimize your tax liability when trading one investment property for another. Making sure that you’re following the IRS guidelines carefully matters to avoid an unexpected tax bill. If you’ve never attempted a 1031 exchange before, you may want to talk it over with a tax or real estate professional before moving forward.

Tips for Investing

• You can consider talking to a financial advisor about the ins and outs of completing a 1031 exchange if you own an investment property. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have free introductory calls with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• There are different paths you can take as a real estate investor, and it’s helpful to consider all the options. For example, you could invest in a crowdfunding platform, a REIT or real estate mutual fund. Looking at the pros and cons of each one can help you decide which one most closely fits your risk tolerance and goals.

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