What Is the 1031 Exchange?

In short, the 1031 exchange is a way to defer capital gains and build wealth faster. It’s a timely transition from one piece of real estate to another. The term “1031 exchange” originates from the Internal Revenue Code’s Section 1031.

“Also known as a tax-deferred exchange, when done properly, it allows the seller of real estate to defer their capital gains until sometime in the future,” Skinner said.

This program allows for the sale of a property that was held for business or investment purposes. That property is sold, another business or investment property is purchased, and taxes are deferred to a later date. Those who use the 1031 exchange can only do so with what is referred to as “like-kind properties.” In other words, it must be used for the same or similar purpose as the prior property.

There are multiple types of 1031 exchanges, including delayed exchanges, reverse exchanges, and build-to-suit exchanges. A delayed exchange is what most people use, and is when a property is sold, and the replacement property is closed on within 180 days or a finite timeframe. Next, a reverse exchange is used when you sell the old property after closing on the replacement property. Lastly, a build-to-suit exchange is where an investor uses the deferred tax dollars from the sale of the old property to make renovations to the new property.

Ultimately, proper use of the 1031 exchange allows you to change from one property investment to another without realizing capital gains. This makes it possible for investments to grow in a tax-deferred manner, which aids in building wealth faster. Deferred taxes are due upon final sale for cash (rather than being held in escrow for the next property swap). In the end, it results in a single long-term capital gains tax payment, instead of one at the time of each property swap.

Who Might Consider the 1031 Exchange?

There are many reasons to consider the 1031 exchange. For example, you might choose to invest in a bigger, better property. Maybe it offers a better return on investment than your current real estate. Additionally, you might choose to consolidate multiple investment properties into one.

“If you are selling property and stand to make a significant return on investment and intend to reinvest most or all of the money into more real estate, a 1031 exchange might be a good option,” Skinner said.

Also, 1031s are sometimes involved with estate planning. Under normal circumstances, the 1031 tax deferral is due upon final sale (for cash). However, tax liabilities cease upon death. Therefore, if the property remains in the 1031 exchange, and your heirs inherit the property, it’s possible they won’t have to pay the deferred tax, especially with a stepped-up cost basis.

“Finding the perfect replacement property can take time,” Skinner said. “Typically, the best exchanges happen when the right buyers and sellers collide. Having some flexibility on closings, etc. can make things go more smoothly. If you decide this is what you want to do, call your land specialist ASAP. Don't wait. Oftentimes, we can mine our database for the right buyer and seller to make the entire process much smoother and less stressful.”

Who Should Not Consider the 1031 Exchange?

Of course, if you’re anticipating needing the cash of a property sale for something outside of securing a replacement property, a 1031 exchange isn’t for you. Obviously, other scenarios might serve as disqualification.

“If you have no intention of reinvesting most or all of your proceeds from the sale of the property you are relinquishing, or you don’t stand to make a significant return on investment, then a 1031 is likely not in your best interest,” Skinner said.

“The 1031's are not intended for use by flippers,” Skinner continued. “You cannot use a 1031 exchange if you purchase the property with the intent to sell. Lastly, these exchanges defer long-term capital gains, which is defined as longer than 12 months. If you've owned the property for less than 12 months, it would be considered short-term gain, and taxed the same as your regular income tax rate.”

Important 1031 Exchange Rules to Know

There are numerous 1031 exchange rules to follow. In fact, there are far more than covered here. That said, the following are of special note.

In most cases, for the 1031 exchange to apply with complete deferral of capital gains taxes, the new property must be equal or greater in value to the old property. If the new property is of lower value, or if the mortgage (loan) applied to the new property is lower than the old property, some (but not all) taxes can be deferred.

Some other rules with 1031 exchanges include:

• There is no limit on 1031 exchange frequency use (if used properly).
• To qualify for the 1031 exchange, properties must be for “business” or “investing.”
• All 1031 exchange properties must be “like kind” or of the same purpose.
• Money from a property sale must be held in escrow by a qualified intermediary.
• Money held in escrow must be a qualified third party.
• The landowner of the sold property cannot receive the funds from the property sale.
• A proper 1031 exchange property swap will require no tax (or minimal tax) due upon the transaction.
• Be aware of special rules, such as depreciation recapture.
• Special rules and restrictions apply to 1031 exchange application to vacation homes.
• The 1031 exchange does not apply to principal residences.

The above certainly aren’t the only rules to follow. Others are even more nuanced and require some juggling to keep all balls moving and in the air.

For example, the 45-day rule requires you to state (in writing) a replacement property. Multiple properties can be listed (generally up to three), but eventually, you’ll have to close on one of these for the 1031 exchange to remain in effect.

Furthermore, the 180-day rule applies to delayed exchanges. Property sellers must close on the new (replacement) property within 180 days of the previous property sale. The 45- and 180-day timelines run concurrently, not sequentially.

“Abide by the strict timeline,” Skinner said. “You must name up to three replacement properties within 45 days of closing on the property you sell. Then, you must close on purchase of the replacement property within 180 days of closing on the property you sell.”

Because of the time limits applied to 1031s, competitive markets make it more difficult to find and close on new properties. That said, when the market is slower, it’s possible to find better deals.

If any proceeds or leftover cash remain in escrow after the new property is purchased, these are distributed to the seller as “boot.” Oftentimes, these funds are treated as capital gain, and are taxed as such.

As expected, there’s plenty of paperwork involved with the 1031 exchange. Form 8824 must be completed (in detail) and submitted with your tax return. This must be done during the same year that the exchange occurs.

1031 Exchange Mistakes to Avoid

Implementing the 1031 exchange doesn’t come without challenges to overcome and mistakes to avoid. Because of the significant complexity of the tax code, certain challenges arise:

• Use of the 1031 exchange requires significant understanding of the U.S. tax code.
• There are numerous nuanced elements to understand with 1031 exchanges.
• Certain timeframes must be met, which can prove quite challenging.
• If 1031 requirements are not met, it can trigger a series of tax-based events.

“Anyone who is looking at selling real estate and reinvesting should absolutely discuss this with their land specialist,” Skinner said. “They likely have contacts who are 1031 specialists that can handle the transaction to avoid any pitfalls.”

For example, when considering loans, debt on the original or replacement property can be a stumbling block. Even if you don’t receive cash back, you might owe certain taxes. If liability decreases, this can be treated as income the same as cash (and considered boot). Therefore, if the mortgage on the new property is less than the old one, this can come into effect.

“I see people not understanding that you must reinvest 100% of your basis (the original investment plus any improvements made during ownership) before any capital gains will be deferred,” Skinner said.

Furthermore, ensure you follow proper guidelines on timing and qualifications for intermediaries.

“The worst mistake I see made when it comes to 1031's is not notifying your land specialist and assuming the process is as simple as selling one and buying another,” Skinner said. “It is not. This process must be started prior to closing on the sale of your property. You cannot receive the proceeds from the sale. You must have a qualified intermediary in place to receive and hold the proceeds until such time as you close on the replacement property. And the QI cannot be your personal attorney or accountant.”

A 1031 Exchange Example

Skinner offers an example to better illustrate the 1031 exchange. Say you purchased a property for $100,000 and sold the property five years later for $200,000. During ownership you spent $10,000 on improvements to the property. Your basis would be $110,000, profit $90,000.

“Many people think all you need to do is spend the $90,000 to defer taxes,” Skinner said. “This is wrong. To defer any capital gains, you would have to spend all the basis plus a portion or all of the gains. If you spent $150,000 on the replacement property, you would realize a gain of $50,000 and would defer capital gains on $40,000.

1031 Exchange Conclusion

In conclusion, the 1031 exchange can be a great wealth-building tool. That said, without question, those who plan to implement the 1031 exchange must consult financial, legal, and real estate professionals.

“Start by working with a land specialist,” Skinner said. “I have two or three well-versed 1031 companies I work with routinely that can answer questions and guide you through the process.”