If you’re new to real estate investing, you’ve probably heard about 1031 exchanges and how they can be a solid part of your tax strategy. That’s all true, but first, you need to understand how 1031 exchanges work to use them to your advantage.
There are different types of 1031 exchange, what makes a property eligible, rules about who can facilitate one, and specific time limits. These are all important things to understand before attempting a 1031 exchange, and that’s why I’m breaking it all down in this article, including examples and the exact steps to complete a 1031 exchange.
1031 Exchange Basics: Understand the Rules & Requirements
What is a 1031 exchange?
A 1031 exchange is when you exchange one investment or business property for another one. It’s named for section 1031 of the U.S. Internal Revenue Code and is defined by the IRS as “like-kind exchanges” because you’re swapping one property for another that you’ll use the same way. As in one investment property for another investment property.
1031 exchanges have potential tax benefits because they’re a way to postpone capital gains tax. They’re popular for investors trying to upgrade their investment property or buy property located somewhere else, and taxes can be deferred almost indefinitely — as long as no monetary benefit is ever received from the sale of a property.
Explaining what like-kind means
Like-kind is an important term to understand when talking about 1031 exchanges. It sounds like the property needs to be nearly identical to the one you’re swapping, but that’s not the case at all. The IRS defines like-kind as properties of the same nature or character, even if they differ in grade or quality.
The idea is that you’re exchanging one investment property for another. An example of a qualifying exchange is a single-family property for retail property. Or a multi-family rental for a shopping center.
The property must be used as an investment — not for resale or personal use. So you can’t sell your mutli-family rental and buy a vacation home and expect it to qualify as a 1031 exchange.
There is a little bit of gray area regarding how long you need to hold a property for it to qualify as an investment property. Although, quick flips or properties you’ve sold quickly to acquire a significant profit most likely won’t qualify. Because there are some ambiguities here, it’s best to consult a tax professional if you’re not sure the property will qualify.
Types of 1031 exchanges
There are a few different kinds of 1031 exchanges:
Simultaneous 1031 exchanges
These exchanges are what they sound like — you’re selling one property and acquiring another one simultaneously. This can be two property owners swapping deeds or having a third-party facilitator setting up a simultaneous exchange between sellers and buyers.
Deferred or delayed 1031 exchange
In a deferred exchange, the buyer and seller are exchanging properties at different times. These are a little more complex, but they give you more flexibility.
The IRS says the properties “must be mutually dependent parts of an integrated transaction constituting an exchange of property.” These types of exchanges, because of their complexities, property owners generally use exchange facilitators to process delayed exchange.
This is an even more complex type of 1031 exchange, as it involves parking your replacement property with an exchange accommodation titleholder for no more than 180 days. During that period of time, you have a maximum of 45 days from the date you purchase the new property to identify which of your investment properties you want to sell. You must complete the sale of your property and finalize the exchange within that 180 day period.
Reverse exchanges aren’t super common, but it’s helpful for the who find a new investment property before their original property sells.
Specifics about 1031 exchange time limits
There are two time limits investors need to pay attention to otherwise, the entire gains you make will be taxable. The IRS even specifies that these limits can’t be extended for any circumstance other than presidentially declared disasters.
Here are the two limits:
- 45 days: You have 45 days from the date you sell your investment property to identify a potential replacement. You’ll need to have that identification in writing, signed by you, and delivered to the property seller or a qualified intermediary. Your real estate agent, attorney, accountant, or similar agents do not qualify as intermediaries.
- 180 days: You must finalize the sale of the replacement property no later than 180 days after the sale of your original property.
How to calculate the cost basis of your properties
The cost basis is the price you pay for acquiring a property, which includes the purchase price and any acquisition costs. You’ll need to accurately track your cost basis to comply with 1031 exchange rules.
Property you sell
The cost basis of the property you sell includes how much you paid for the properties, the fees associated with selling it (including legal and lender fees), and any improvements you’ve made over time. But you can also claim depreciation costs, which move the cost basis of your property down over time.
So the cost basis of the property you sell is the cost of the property + capital improvements - cumulative depreciation.
Property you acquire
The cost basis on your new property is the basis of your sold property with some adjustments. To figure out this number, you start with the cost basis of the original property, then:
- Add the value of any other property transferred in the exchange, the mortgage amount on the replacement property, the amount of cash you’re contributing to the new purchase price, and any recognized gain on the sold property that you may have taken. Not all of these factors will apply to every 1031 exchange.
- Subtract any money or property you receive in exchange, the amount of the mortgage on the sold property, and any recognized loss on any property sold in this exchange.
When you sell the replacement property (as long as it’s not part of another 1031 exchange) you’ll pay taxes on the original deferred gain, plus any additional gains realized since purchasing the replacement property.
You need third-party help for 1031 exchanges
1031 exchanges aren’t the time to go at it alone, and the IRS requires an impartial third party to set up the exchange. These people are called exchange facilitators. They can be a qualified intermediary or a trustee, escrow holder, transferee, or another person that holds exchange funds for you in the event of a deferred exchange.
You cannot use your real estate agent, relative, or person related to your real estate agent. Your accountant, banker, or lawyer also cannot be used. If someone has served in you in any of those capacities in the last two years, they are ineligible.
Basically, the qualified intermediary cannot have a conflict of interest with the exchange. And as you can imagine, it’s important to have someone who is qualified and reputable to act as the qualified intermediary.
Roofstock can help with 1031 exchanges
Roofstock is an online marketplace for rental properties, and they can help you find eligible properties, refer you to qualified intermediaries, and hit important deadlines.Check out Roofstock
How to complete a 1031 exchange
Now that you’ve read how 1031 exchanges work, about 1031 exchange rules and time limits, and calculating costs, here are the steps to put everything together:
Step 1: Identify the property you want to sell
Unless you’re doing a reverse 1031 exchange, most property owners know which property they want to swap as part of the exchange. Remember, only investment properties are eligible, not your primary residence or a vacation home.
Step 2: Identify the property you want to buy
You must find a property that is like-kind, and that only means you’re using it as an investment property. It can be exchanging a single-family rental for a multi-family or retail space for a hotel. The new property must be within the U.S. to qualify.
Step 3: Find a qualified intermediary
Your real estate agent, banker, accountant, or anyone with a conflict of interest will not be eligible as a qualified intermediary. An independent third party must fill this role. You can hire a lawyer with real estate experience, CPA, an investment broker, or someone else with relevant experience is ideal. It’s just important that they haven’t served you in any capacity in the past two years.
Step 4: Decide how much of the sales proceeds you want to reinvest
When you sell the original property, you can put as much of those sale proceeds towards the new property as you want. There are no rules that say you have to reinvest all of the proceeds in your 1031 exchange. However, you can only defer capital gain tax on the portion you reinvest.
Step 5: Pay attention to time limits
There are two important time limits you’ll need to pay attention to. You have 45 days from selling your property to identify a replacement, and you must complete the sale on the new property no later than 180 days after selling your old property.
Step 6: Report your 1031 exchange to the IRS
You must report the exchange to the IRS using Form 8824, and it will need to be filed with your tax return in the year the exchange occurred.
Here’s what you’ll need for Form 8824:
- A description of the properties exchanged
- Identification and transfer dates
- Any relationship between the parties to the exchange
- Value of the like-kind and other property received
- Gain or loss on the sale of the property given up
- The cash you may have received or paid
- Adjusted basis of like-kind property given up (realized gain)
Beware of 1031 exchange schemes
When you exchange qualifying property, 1031 exchanges are entirely legal ways to defer capital gains tax, but there are those promoting exchanges that aren’t legal. The IRS warns of people claiming to be tax professionals who want to help you exchange non-qualifying properties, like a vacation or second homes. Sometimes they use phrases like “tax-free” to describe what they’re offering.
Just remember that 1031 exchanges aren’t tax-free and what kind of property qualifies. If you’re ever unsure, consult a tax professional.
The final word on 1031 exchanges
A 1031 exchange is a legitimate and strategic way to defer taxes on the sale of investment property. They’re an excellent strategy when you follow the rules and understand how 1031 exchanges work.
1031 exchanges can be a little complex, but the reality is that as long as you work with a qualified intermediary who knows what they’re doing, you’ll be able to adhere to the time limits and accurately calculate your costs.