For years, the prospect of paying taxes on capital gains for property transactions had been a hindrance to those involved in real estate investment. Why should real estate investors pay taxes on profit from transactions if they’re putting the profit right back into some other real estate transaction?
The answer: They shouldn’t.
That’s exactly why the IRS created 1031 exchanges: to allow for tax deferment on profit that is reinvested immediately. Notice that a 1031 exchange is a deferment, not a credit or reduction. Although taxes don’t have to be paid at the time of sale, they do have to be paid eventually.
What Is a 1031 Exchange?
A 1031 exchange, according to Section 1031 of the Internal Revenue Code, allows you to make a like-kind swap of one piece of real estate investment property for another without incurring capital gains taxes – as long as the exchange is completed according to IRS rules and the new property is of greater or equal value.
According to Section 1031 of the Internal Revenue Code, “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment.” Think of it as swapping one real estate investment for another, with deferred taxes on capital gains.
Section 1031 was created to encourage the reinvestment of the sale proceeds of a property into a similar property in order to stimulate business and growth. As long as the investor continues to put profit back into more property, taxes are not owed.
How Do 1031 Exchanges Work?
The nuts and bolts of how 1031 exchanges work can be complex – and the IRS can be very particular – so it’s best to work with a financial professional if you’re contemplating a like-kind swap. Essentially, for a 1031 exchange to work, the property you’re selling and the property you’re buying must be of the same nature. In this case, they both must be real estate investments. It doesn’t matter if you’re selling a flipped property and buying a vacant piece of land. It’s still a like-kind exchange. With a this kind of transaction, you can even switch your investment focus from high-maintenance rental homes to newly built apartment buildings.
For example, let’s say you invest in a house in Detroit that costs you $100,000. You put $50,000 into the house and then sell it for $250,000. You take the $100,000 profit – or capital gain – and purchase another property that you buy to fix up and sell. This continues, and all of your capital gains are deferred with a 1031 exchange up until you sell your final property and enjoy the profit. At that point, you have to pay all taxes owed.
Timing The Exchanges
The IRS allows 1031 exchanges to be structured in one of four ways: simultaneous, delayed, reverse and construction/improvement.
With a simultaneous exchange, you are essentially buying and selling real estate as close to the same time as possible – or actually swapping the property you are selling for the property you are buying. But because any delay can jeopardize the exchange, and if the exchange fails, you can say goodbye to the tax advantages.
Delayed exchanges are by far the most popular type, and are sometimes referred to as Starker exchanges, after the decision in Starker vs. United States, which ruled that a property owner can sell their property, transfer any proceeds from the sale to a qualified intermediary – who must be a neutral party with no connection to either buyer or seller – and then have that intermediary purchase the new property. Additionally, for a delayed exchange you’ll need to do the following:
- Identify the property you wish to buy within 45 days of the sale of the original property.
- Close on the property within 180 days.
- Purchase a property that has an equal or greater value than the one you sold.
- Taxpayers must file a Form 8824 along with their tax return to report the 1031 exchange.
In this type of exchange, an investor buys the property they’re interested in before selling the property they currently own. These types of exchanges generally follow the same rules as delayed exchanges in reverse, in that investors have 45 days to identify the property to be relinquished and 180 days to complete the sale of that property. These tend to be all-cash deals, as banks generally will not issue loans for reverse exchanges.
Construction Or Improvement Exchange
If the investor trades their buildings for vacant or underdeveloped land, they can use the proceeds from the sale of their property, transfer it to a qualified intermediary and have that intermediary pay for construction to improve the property. To qualify, the following is required:
- The entire exchange equity must be built by the 180th day after the sale.
- The investor must receive “substantially the same property” that the investor reported to the IRS on the 45th day.
- When deeded back to the taxpayer, it must be of equal or greater value.
What About Depreciation Recapture?
A 1031 exchange means you avoid capital gains taxes, but in some cases, you may owe income taxes. If you’ve owned the property for a while, you may have taken depreciation deductions that have reduced the property’s net adjusted basis, which is the original purchase price plus capital improvements minus depreciation. If you sell it for a price higher than the net adjusted basis, the depreciation is recaptured, which means that the gain above the net adjusted basis is taxable as income.
Moreover, any money left from the sale of the first property after the purchase of the second property, sometimes called “boot,” is also taxable as income.
This is why it’s important to make sure that the property you want to buy is of equal or greater value. And debt counts! If your old mortgage was $500,000, and your new mortgage is $400,000, that reduced debt liability counts as boot, and you will owe taxes for $100,000 of income.
1031 Exchange FAQs
Here are some of the most commonly asked questions about the rules of 1031 exchanges:
Can I Do A 1031 Exchange For Any Type Of Investment Property?
Unfortunately, not all investment properties are eligible for a 1031 exchange. The 2019 Tax Cuts and Jobs Act eliminated the use of 1031 exchanges for qualified personal property, including intangibles like franchise licenses.
What Is The Benefit Of A 1031 Exchange Vs. Just Selling Property?
A Section 1031 exchange is one of the few ways investors can defer taxes due on the sale of property (assuming it qualifies for a 1031 exchange). Deferring taxes allows investors access to the money that would otherwise be paid in taxes in order to reinvest.
What Are The General Guidelines To Follow In Order To Defer All The Taxable Gains?
According to the IRS, the value, equity in and debt on the new property must be equal to or greater than the value of the property being sold for a 1031 exchange to be valid. All of the profit from the property sale must be used to buy the new property. If even a small percentage of the profit is used for something else, the 1031 exchange is not valid.
If There’s Already A Contract To Sell The Property, Is It Too Late To Start A Tax-deferred Exchange?
As long as there hasn’t been a transfer of title or a closing on the sale of the property, a tax-deferred exchange can still be arranged. Once the closing occurs, however, it’s too late.
Can The Replacement Property Eventually Become The Investor’s Primary Residence Or Vacation Home?
The secondary property can become a primary residence or vacation home, but Section 1031 has holding requirements (i.e., the minimum length of time the new property must be owned) that must be met prior to changing the primary use of the property. The IRS has no specific regulations on holding periods, although a minimum of a year is recommended. Instead, the IRS reviews situations on a case-by-case basis. But if the owner wants to take advantage of the home owner’s capital gains exemption (up to $250,000 or $500,000 for a couple) for capital gains taxes on the primary residence in the future, there is now a five year holding period requirement.
Learn How 1031 Exchanges Can Help Your Real Estate Portfolio Grow
If you own an investment property, knowing how 1031 exchanges work will help you keep your real estate portfolio growing by allowing you to reinvest all your money into new investments. Learn more about investing in real estate in our Learning Center.