What is a 1031 Exchange?

Many real estate investors are wondering what a 1031 exchange is. If you want to upgrade your real estate, 1031 exchanges are a great way to do this while keeping your taxes low.

There are some requirements and deadlines to keep in mind. We’ll walk through the requirements, timelines, and share some examples.

What is a 1031 Exchange?

A 1031 exchange allows an investor to sell a property, and reinvest the proceeds into a new property to defer all capital gains. You essentially swap your property for another tax-free.

The IRS code states: “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.”

Requirements of a 1031 Exchange

A 1031 Exchange is Not for Personal Use

You can only exchange business and investment properties. If you did move from your primary residence, you could rent it out so it will qualify in the future. Doing this could save you a killing in taxes.

“Like-Kind” is Broad

While the tax code says “like-kind”, the rules for exchanges are surprisingly liberal. You can exchange almost any type of real estate for another.

For example, you could exchange an apartment building for a strip mall.

Equal or Greater Debt & Equity

If an investor sells a property for $500k, $250k in debt and $250k in equity, they would then need to purchase at least $500k of new property.

If you do not use all of your proceeds for the new purchase, any net difference would be taxed capital gains. This shouldn’t be a huge deal, since the whole point of 1031 exchanges is to upgrade real estate tax-free.

You Must Designate the Replacement Property

Once you sell your property, your intermediary will receive the cash. Make sure you don’t receive the cash, or that will spoil the 1031 treatment.

Within 45 days of the sale, you must also designate the replacement property in writing within 45 days. The IRS allows you to designate three properties so long as you close on one of them.

You Must Close Within 6 Months

You must close your new property within 180 days from the property you sold. The clock starts as soon as your sell your property.

If you found your replacement property in 45 days, like in our example, you would then have 135 days to close on the replacement.

Example of a 1031 Exchange

Suppose that a real estate investor sells a property they purchased for $200k for $300k. The investor will need to pay capital gains on the $100k they made, which will be roughly $35k.

Since the investor owes $35k in taxes, they can only put $265k into a new property. Assuming that will be used for a 25% downpayment, the investor will only be able to afford a $1.06 million property.

If the investor chose to make a 1031 exchange instead and deferred their taxes, they would be able to invest all $300k in a new property. Assuming the same 25% downpayment, that investor can now afford a $1.2 million property instead.

What is a 1031 Exchange – The Bottom Line

1031 exchanges are a great way to upgrade real estate properties tax free. By swapping your investment for another, you’ll defer the capital gains taxes and can use more capital for your next property.

There is a 6 month deadline for this, so make sure you have your new property in mind before starting the process. Also, it cannot be for personal use. If you need to move and would owe a ton of capital gains on your house, explore renting the property so it could qualify in the future.

Real estate is a great way to defer taxes and build wealth. Make sure to consider it in your hierarchy of savings, and work with an accountant so you can maximize this and any other tax breaks.