How Does a 1031 Exchange Work for Real Estate Investors?

What is a 1031 Exchange

A 1031 exchange is the act of swapping out one investment property for another, in order to avoid paying federal capital gains tax. This mechanism, named after section 1031 of the tax code, can defer up to 20% in taxes on the proceeds from a sale for real estate investors, so it makes sense that it's a common tool in the savvy investor’s toolbelt. 

As with most things, there are some specific rules and regulations for how you can take advantage of a 1031 exchange and we’ll break it down below. 

When can I use a 1031 exchange?

Like-Kind Properties

1031 exchanges are only applicable for what the IRS deems “like-kind properties”, meaning of the same nature or character, even if they differ in grade or quality.” The interpretation of this phrase is fairly liberal and allows for things like swapping unimproved land for an apartment building. But there are exceptions to the rule that could trip you up. For example, a property in the United States would not be considered like-kind to a property in another country. For this reason, it’s important to consult a tax professional or 1031 exchange specialist before making any big moves. 

Vacation Homes

There used to be more ambiguity about whether or not mixed-use vacation homes qualified as investments, which would therefore be eligible for a 1031 exchange. However, in 2008, the IRS issued Rev. Proc. 2008-16, which provides a set of “safe harbors” that allow the exchange of second homes. 

To qualify for a 1031 exchange, you must restrict your personal use to two weeks or 10 percent of the time it’s rented for two years before you “relinquish” or sell a property. Similarly, the property you acquire or “replace” via an exchange must be held for two years and is subject to the same rental restrictions as above.  

Delayed 1031 Exchanges and Timing Rules

In an ideal situation a 1031 exchange between two properties would happen concurrently. But, the odds of finding the perfect property, immediately after you sell the first is fairly unlikely. For this reason, most 1031 transactions are “delayed exchanges” or “Starker exchanges.” 

With any 1031 transaction, you’ll need to find someone to act as a “qualified intermediary.” This is the person who holds the cash from your first sale and uses it to acquire a new property. 

45 Day Rule 

One you sell or “dispose” of your property, the money must go directly to the qualified intermediary. If you touch the money at all during the process, you will no longer qualify for the capital gains deferment. On top of this, you need to designate a replacement property in writing to your qualified intermediary within 45 days. You can submit multiple properties but you must eventually close on one of them.  

180 Day Rule

This rule just means that you must close on the replacement property within 180 days. But, it’s important to note this is 180 days from the original sale. Meaning, once the period of the initial 45 day rule is up, you only have 135 days to close on a property.

1031 Exchange Title & Closing Tips

Avoiding the “Boot”

Since the big incentive for utilizing a 1031 exchange is to defer federal capital gains taxes, you want to make sure that the new property you invest in costs as much or more than the previous property. For example, say you sell a property for $600,000 and buy a property for $500,000, you would be responsible for paying taxes on the $100,000 you gained from the transaction. This gain is referred to as a “boot” and it will be taxable in both all cash and financed purchases.

1031 Exchange Eligible Closing Costs

One of the other ways to incur tax penalties is to use exchange funds for closing costs that are not eligible per the IRS. Fortunately, the IRS provides examples of common closings costs that are eligible such as:

  • Escrow fees
  • Broker’s commissions
  • Mandatory appraisal costs (purchase contract only)
  • Attorney costs related to the sale
  • Recording fees
  • Title insurance costs
  • Transfer taxes
  • Prorated taxes
  • Qualified intermediary fees

Costs Not Covered by 1031 Exchange Funds

While the closing costs listed above are all eligible for 1031 funds, the following common expenses are not eligible. If you use exchange funds to pay for these costs, you could incur tax penalties or completely invalidate the 1031 exchange. 

  • Costs of financing
  • Prorated rent
  • Security deposits

More 1031 Exchange Fine Print

State Statutes

The 1031 exchange deferment only applies to federal capital gains taxes, and some states also have statutes that would require payment on capital gains

Fix and Flip Investors

Some real estate investors try to take advantage of the tax benefits when they own fip and sell companies. 1031(a)-1 is slightly ambiguous but clearly excludes "property held primarily for sale." So there have been questions about whether or not a buy and sell business, or flip company would qualify under 1031. 

Bottom Line

It’s clear that there are lots of moving parts to doing a 1031 exchange the right way. But, the major tax incentives make it an extremely attractive vehicle for many real estate investors. As with any big financial decisions, it’s important to enlist your financial advisor, a reputable 1031 exchange specialist, and title & closing company that’s familiar with investor transactions.

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