When you hold an asset like an investment property for longer than one year and sell it for a profit, you pay capital gains taxes on that profit. Maybe. Or maybe not if you use tax loopholes like a 1031 exchange to postpone paying capital taxes indefinitely.
In fact, many real estate investors use 1031 exchanges to continually roll profits from each property into ever-larger income properties, never paying a cent in capital gains taxes until the day they decide to sell off their portfolio — a day that never comes for some lifelong investors.
As you explore ways to lower your taxes as a real estate investor, add 1031 exchanges to your tax-shrinking toolkit.
What Is a 1031 Exchange?
Not-so-creatively named after the section of U.S. tax code that details them, 1031 exchanges allow investors to “swap” one property for a similar property without paying capital gains taxes, which are taxes on the profit of the sale.
It initially applied when two parties swapped properties with one another. But nowadays, most people use 1031 exchanges to sell a property then use the proceeds to buy another from a different seller.
Investors defer or postpone paying capital gains taxes until they sell without buying a replacement property.
Historically, citizens could perform a like-kind exchange on any type of personal property, such as franchise licenses, aircraft, and equipment. However, that changed under the Tax Cuts and Jobs Act of 2017, which no longer allows 1031 exchanges for personal property. Only real estate qualifies under the new tax rules.
How Does a 1031 Exchange Work?
In broad terms, you sell an investment property and earn a profit. You can pay capital gains taxes on that profit or reinvest it in another property. But you have to follow specific rules when reinvesting to defer paying capital gains taxes.
The properties you’re selling and buying must be “like-kind” investment properties. That means they must be similar in nature.
For example, you can upgrade a single-family rental property to a duplex or an apartment building to an office building. You can’t move money to an entirely different type of investment, such as selling a rental property and using your proceeds to buy shares in real estate crowdfunding platforms.
You also can’t 1031-exchange your primary residence. Before you cry foul that real estate investors get unfair tax breaks, know that this rule exists for a good reason. Homeowners don’t need it.
They already benefit from the homeowner exclusion, which exempts them from paying capital gains taxes on the first $250,000 of profits ($500,000 for married couples) when selling their home. In other words, most homeowners don’t pay capital gains taxes when they sell their home, anyway.
Types of 1031 Exchanges
Depending on the order you buy and sell your properties in, there are a few different types of exchanges.
In a simultaneous 1031 exchange, you sell your old property and buy the new one on the same day.
Simultaneous exchanges rarely happen in the real world. Often, you need the proceeds from selling the old property to afford to buy the new one, and it takes time for funds to clear. Plus, purchasing real estate remains a messy, complex process, and the industry ranks among the slowest to adopt innovative technology — in part because it relies so heavily on government records.
A deferred or delayed exchange is the most common type of 1031 exchange and occurs when you sell one property and then buy the new one days, weeks, or months later.
And that makes sense. It takes time for funds to clear in your account, title companies to research the title history, or mortgage lenders to underwrite loans.
But you must declare and settle on the new property within 45 days.
In a reverse 1031 exchange, you buy the new property before selling the old one.
These happen less frequently since many investors need the proceeds from the old property to afford the new one. But the tax code still allows you to declare the two properties and settle the new one before you sell the old.
1031 Exchange Rules and Time Frames
To qualify for a 1031 exchange, both you and your real estate deal must meet certain criteria.
In addition to both the old and new properties being like-kind, adhere to these 1031 exchange rules.
Second Property Must Be of Equal or Greater Value
To capitalize on the 1031 exchange tax break, the new property must cost at least as much as the property you sold. Otherwise, investors could scale down their portfolios without paying taxes either.
If you buy a replacement property at a lower price, you get taxed on the difference in value, which is called the boot.
There Are Time Limits
There are two time limits you need to remember when doing a 1031 exchange.
After you sell your old property, you have 45 days to declare a new replacement property. It’s known as the 45-day rule. You have to submit the details about your upcoming property purchase to a qualified intermediary (third party). But the IRS recognizes that sometimes deals fall through, so they allow you to specify up to three potential properties.
That raises the second time-based rule: the 180-day rule. You have up to 180 days (about six months) to settle on the new property after you sell the original.
Note that the clock starts ticking on both time requirements from the day you close on selling your first property. That means the 180-day rule also starts then, not when you declare your new property or submit your property options.
A Qualified Intermediary Must Hold the Funds
When you do a 1031 exchange, you can’t touch the profits from the relinquished property. You need to pay a disinterested third party — a qualified intermediary — to hold the money for you in escrow between when you sell one property and buy another.
Then, the qualified intermediary must buy the new property on your behalf and then transfer the deed to you afterward.
There are no licensing requirements to become a qualified intermediary, but you can’t use a parent, child, spouse, or sibling. You also can’t use someone already serving as your agent, such as your real estate agent, accountant, or attorney.
Some banks, such as Wells Fargo, offer to serve as a qualified intermediary on your behalf, but they charge a fee. You can also find qualified intermediary services online, such as First American Exchange or IPX 1031. In fact, anyone you know who’s not a family member, financial connection, employee, or agent can serve as a qualified intermediary for you.
But they must fill out some paperwork, both to become one, such as getting a QI-EIN (a number assigned by the IRS) and throughout the transaction. Your qualified intermediary will help you with your tax return paperwork as well.
In most cases, you’re better off just hiring a service, as they already know all the paperwork inside and out.
Applies to Income Properties, Not Flips
The 1031 exchange was designed for long-term investments, not rapid house flipping. Specifically, the IRS rules state that you can’t exchange properties held primarily for resale.
Like-kind exchanges help you postpone or avoid long-term capital gains taxes, which apply to assets held for at least a year, not regular income taxes on short-term profits. If you want to use a 1031 exchange, hold your property for at least a year before selling it.
How a 1031 Exchange Impacts Your Taxes
Using a 1031 exchange doesn’t remove your obligation to pay capital gains tax on your profits. It simply defers it to a later date, when you sell the replacement property.
But you can keep kicking the proverbial can down the road indefinitely. Say you buy a small rental property that generates $150 per month when you first start investing in real estate. After a few years, you decide to upgrade.
So you sell your single-family rental and combine the sale proceeds with your savings to buy the new three-unit property that generates $500 per month. With a 1031 exchange, you defer paying capital gains taxes on your profits from selling the single-family rental.
A few years later, you repeat the process, selling the three-unit property and buying a six-unit property that cash flows $1,000 per month. Again, you defer paying capital gains taxes on the three-unit building you sold by using a 1031 exchange to roll the profits into the new purchase.
In short, you keep snowballing the profits of your real estate to trade up to ever-larger buildings with greater cash flow. And you do it all without paying a dime in capital gains taxes as you upgrade from one property to the next.
Boot, Debt, & Cash
If you have cash left over from the sale of your old property that doesn’t go toward buying the new property, the qualified intermediary returns it to you 180 days after you closed on selling the old property. The IRS taxes this surplus cash as capital gains.
It’s known as “boot.” It’s based on the Old English word meaning “something in addition to” — today rarely used outside the expression “to boot.”
It’s straightforward enough. But beware that boot covers not only the cash you receive but the difference in debt levels.
Say you sell a property for $300,000, and $200,000 of it goes toward paying off a mortgage. The other $100,000 goes to the qualified intermediary to help fund the replacement property and pay closing costs. The boot principle applies not just to the $100,000 in cash but also to the $200,000 in debt.
To avoid any capital gains taxes, just follow a few simple ground rules. First, the new property should cost you at least what you sold the old property for — in this case, $300,000. Also ensure your new debt exceeds the old debt you paid off and reinvest all net equity from the old property.
Pros and Cons of a 1031 Tax-Deferred Exchange
It’s crucial to understand the advantages and disadvantages before committing to a 1031 exchange.
Pros of a 1031 Exchange
For real estate investors, 1031 exchanges have multiple advantages.
- You Could Delay Taxes Indefinitely. You can keep rolling your profits into properties that yield ever more passive income to live on in retirement. Leave your kids the property in your will. When you die, the cost basis resets, and your children may avoid capital gains taxes entirely.
- You Can Reset Depreciation. With a 1031 exchange, you may be able to up your building depreciation tax deduction to the adjusted basis of the property you sold to take more depreciation. But talk to your accountant, as it gets complicated quickly.
- You Can Trade One Property for Several. You can sell one expensive property and put the proceeds toward buying several cheaper properties. But this comes with several rules, so speak with a 1031 exchange custodian before attempting it.
- You Have the Flexibility to Improve Your Portfolio. Properties can be repair-intensive, have high-maintenance tenants, or be in areas with less favorable rental property owner laws. Like-kind exchanges let you swap your duds for higher-yield properties in more investor-friendly markets without having to pay the taxman.
Cons of a 1031 Exchange
Even flexible tax rules come with their downsides. It’s crucial to understand the potential downsides to ensure you don’t experience complications.
- It’s a Tight Timeline. It often takes time to find good deals on investment properties. But if you hope to do a 1031 exchange, time isn’t necessarily on your side once you sell a property.
- You Must Hire a Qualified Intermediary. When you do a 1031 exchange, you have to hire a qualified intermediary to hold your funds in escrow. That costs money, and the whole process in general adds wrinkles to your tax reporting.
- It Reduces Depreciation Deductions. Even after buying a replacement property, your depreciation remains based on the original property. That generally means lower depreciation for your tax bill each year than you’d have been able to take if you’d bought the replacement property without a 1031 exchange.
- You May Experience Tax Complications. If you have any profits after buying the new property, you pay capital gains taxes. If you take out a lower loan than you originally had, the IRS also taxes the difference as boot. Depreciation recapture can add its own complications. Speak with an accountant or qualified intermediary before you try this at home.
How to Do a 1031 Exchange
You’ve decided to sell an investment property and replace it with a new one. Follow these steps to complete your 1031 exchange.
- List your old property and hire a qualified intermediary to handle the exchange for you.
- At settlement, the funds go directly to the qualified intermediary, not to you. They deposit them into an escrow account on your behalf.
- Declare to your qualified intermediary the address of a new replacement property you plan to purchase within 45 days of selling your old property. You can provide up to three options.
- Within 180 days of the settlement date of the old property, you must settle on the new replacement property. Your qualified intermediary provides the funds they held in escrow, and you provide the remaining balance. As part of their fee, the qualified intermediary helps you with the tax paperwork.
1031 Exchange FAQs
Since 1031 exchanges involve some legal gymnastics, most people have plenty of questions about them the first time around.
What Is a Tax-Deferred Exchange (in Real Estate)?
A 1031 exchange, also known as a tax-deferred exchange or like-kind exchange, involves selling an investment property and using the proceeds to buy another. When you do so, you defer paying capital gains taxes on your profits after selling real property.
Can You Do a 1031 Exchange on a Primary Residence?
No, you cannot do a 1031 exchange on your home.
However, you can convert a rental property you previously bought through a 1031 exchange into your primary residence so long as you’ve owned it for at least two years (defined as 12 months, not calendar years) before moving in.
You must rent it out at fair market pricing for at least 14 days in each of those two years. And you can’t use the property yourself for more than 14 days or 10% of the days it was rented, whichever is greater, in each of those years.
Even after that, you must live there yourself for at least two years before you can take advantage of the primary residence exclusion.
So, you can theoretically roll your capital gains into an eventual residence and dodge the first $500,000 in taxes on them, but it involves a lengthy multistep process to pull off.
Can You Do a 1031 Exchange on a Second Home?
You can’t do a 1031 exchange on second homes, but you can convert one into a rental property.
The IRS allows you to use a 1031 exchange to defer capital gains taxes when you sell it if you meet two conditions:
- For each of the last two years (measured as 12-month periods, not calendar years), you rented the property out at fair market pricing for 14 or more days.
- You limited your personal use of the property to the greater of 14 days or 10% of the number of days you rented it out at fair market pricing within each 12-month period.
Note that you must use the property primarily as a rental for at least two years before you can do a 1031 exchange on it.
What Are the Requirements for a 1031 Exchange?
The old and new properties must be like-kind, which allows most types of investment properties. For example, you can swap a mixed-use property for a residential rental property.
You must adhere to the time limits. Within 45 days of settlement on the old property, you must declare the new like-kind property (or up to three options). Within 180 days, you must settle to buy one or more of them.
The new property must be of greater value than the one you sold. And you must hire a qualified intermediary to hold your profits from the sale in escrow.
Finally, the properties must be long-term income properties, not short-term flips.
What Happens When You Sell a 1031 Exchange Property?
When you sell the replacement property, you still owe capital gains on your accumulated profits unless you do another 1031 exchange.
You can keep rolling profits into new investment properties indefinitely. But if you fail to buy a new property within the time limit, prepare to cough up tax money for Uncle Sam.
What Is Section 1031 of the Internal Revenue Code?
Section 1031 of the IRS code outlines the rules for like-kind exchanges. You can reference the IRS directly if you want more information about it.
Like-kind exchanges offer a great real estate exit strategy to defer capital gains taxes.
They let you optimize and improve your real estate portfolio, cashing out your duds and rolling the proceeds into better properties without having to pay taxes (yet).
But they come with their own quirky rules and complications, which some investors find more trouble than they’re worth. Speak with a qualified intermediary or accountant before starting the exchange process to ensure you understand and can comply with all the requirements.