Some lines in the federal tax code are so widely used and understood that they have become part of our common speech. Terms like “401 (k),” “501c3,” and “W2” will get mentioned in daily conversation, even by the least tax-literate among us.
Other lines of the tax code, however, remain widely unknown or underutilized, even by those who could benefit from this knowledge the most.
The elusive “1031 exchange” is such a provision, with massive potential for real estate professionals but little general knowledge among even the most experienced real estate investors.
In the guide that follows, we’ll break down the 1031 exchange, and how to use it to minimize taxes as a real estate investment professional.
What is a 1031 Exchange?
The 1031 exchange rule is an element of the federal tax code that provides real estate investors with massive financial potential.
Under normal circumstances, when you sell an investment property at a gain, you owe taxes based on that gain at the time of sale. But with the 1031 exchange rule, you can avoid paying that tax at the time of sale and defer it into the future, all while still offloading properties and upgrading your portfolio. Here’s how it works.
In a 1031 exchange, real estate investors essentially “exchange” or trade one property for another. By doing so, any gain on which you would have paid tax is deferred. Property exchanges must be “like kind”. And while a lot of other rules and stipulations apply, the 1031 exchange rule is surprisingly flexible and widely applicable to real estate transactions.
How Does the 1031 Exchange Work?
While exchanging one property for another seems simple enough, it’s rarely the case that a 1031 exchange will result in a straightforward property swap. The odds of finding someone with a property that you want, who also wants the exact property you own, are fairly slim. But that doesn’t make the 1031 exchange rule any less powerful, thanks to a modified form of exchange recognized by the IRS called the “deferred exchange.”
In a deferred exchange, you essentially can sell a property and then use the returns on your sale to buy a new property, and still have the 1031 rule apply. In a deferred exchange, you must rely on a third-party exchange facilitator: if you simply sell a property on your own and then reinvest your earnings, you will pay taxes on the transaction. But by consulting an exchange facilitator, you can avoid these taxes while still upgrading or diversifying your portfolio.
First, you must designate a property as relinquished, and sell it through an exchange facilitator. After your property is sold, you have 45 days to find an exchange property, which your facilitator will then purchase with the gains from your original property. From the time of your relinquished property’s sale, you have six months to close on a replacement property in order for the 1031 rule to apply. That means that if you wait the full 45 days to note a replacement property, you then have an additional 135 days to close on your replacement property. If you can do that, taxes on the transaction will be deferred.
Why is the 1031 Rule So Powerful?
If all of the above sounds like a lot of work, it’s for a good cause. The 1031 rule is an incredibly powerful tool for real estate investment professionals for a number of reasons.
First, deferring taxes means you can keep growing and diversifying your portfolio a lot more quickly than if you had to pay standard tax rates on every transaction. With the 1031 rule, you can essentially “swap up” your properties indefinitely and still benefit from tax deferment. Smart real estate investors use the 1031 rule to swap out an undesirable property, and then use it again to swap out the new property they’ve acquired. This process can be repeated over the long term to assure that your portfolio continues to grow without paying taxes at the time of sale.
Second, the 1031 rule’s power is due to its incredible flexibility. For example, when you designate replacement properties, multiple properties can be designated as potential replacements. You can designate up to three properties, as long as you close on one of them. Or, for multiple property transactions in one exchange, the total value of the potential replacement properties can be up to 200% of the value of the property you are relinquishing. That means that after 45 days, you still have a wide leniency to negotiate the best possible exchange and close within the time limit.
Further more, the properties that the IRS defines as “like kind” don’t have to be identical. Essentially, all real estate for investment purposes is designated as “like kind”: you could exchange a rental property for unimproved land, and still qualify for the 1031 rule. Since classification of “like kind” property is so broad, the 1031 rule is a powerful tool to diversify your portfolio while deferring tax payments.
By not paying taxes at the time of sale in an exchange, investors have a lot more capital to work with, and can bid for higher value properties through an exchange facilitator. By allowing such wide flexibility, the 1031 rule encourages creative deals and is widely powerful as a tool to expand your real estate investment portfolio.
Limitations of the 1031 Exchange Rule
While the 1031 rule is widely flexible, there are some big limitations on the rule that real estate investors should keep in mind. If any of these limitations seem confusing or potentially restrictive in regards to a future deal, make sure to consult a tax professional.
First, 1031 exchanges don’t apply to all property types. While property class, like rental vs. unimproved, generally isn’t a factor, there are types of properties that do not qualify for a 1031 exchange tax deferment. Most notably, primary residences don’t qualify for 1031 exchange deferments. Vacation homes do not qualify either. In both cases, tax professionals have found some creative ways to get around these exceptions, but work arounds will take a while.
Second, 1031 exchanges don’t apply to a wide variety of properties outside of real estate, so be careful not to expect a tax deferment in other investment situations. Specifically, the IRS notes the following common investment types as falling outside the bounds of the 1031 exchange rule:
- Inventory or stock in trade.
- Stocks, bonds, or notes.
- Other securities or debt.
- Partnership interests.
- Certificates of trust.
For real estate investment professionals that deal strictly in property transactions, these limitations may not be applicable. But they are good to keep in mind as your investment portfolio expands and broadens.
Finally, there are some limitations on tax deferment in 1031 style exchanges. If you walk away from an exchange with a profit, you will pay taxes on those gains. To avoid paying taxes, make sure properties you purchase in an exchange have an equal or greater value to the properties you sell. Additionally, you must keep debt factors in mind when exchanging properties. Specifically, mortgage values will be taken into account by the IRS in relation to property values. If you exchange a property with a one million dollar mortgage for a property with an $800,000 mortgage, you will pay taxes on the difference in accrued debt.
How Can You be Sure to Benefit from the 1031 Exchange Rule?
In order to ensure that the exchange you are hoping to make qualifies for the 1031 exchange deferment, there are a few basic steps you can take.
#1 Make Sure the Property You are Exchanging Qualifies
As noted above, some properties won’t qualify. Private residences and vacation homes won’t qualify, but most other kinds of real estate are fair game and can be exchanged.
#2 Make Sure You Don’t Walk Away with Cash
If you are hoping to exchange a valuable property for a less valuable one, consider that any cash you walk away with will be taxed, and those taxes can’t be deferred under the 1031 rule.
#3 Make Sure You Consult an Exchange Facilitator
If you try to handle an exchange on your own, you can run into a lot of trouble. Namely, once you take cash from a sale yourself, that cash can be taxed. By relying on an exchange facilitator, the 1031 rule can apply even with deferred exchanges.
#4 Consult a Tax Professional
There is a lot of great information about the 1031 rule if you are willing to do your research, and the IRS offers a straightforward breakdown of the practice. That being said, you should always consult with a tax professional before making a major exchange under the 1031 rule, just to be safe.
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