1031 Exchange: What Is It In Real Estate?
Want to sell an investment property but you’re worried about getting hit with a sky-high tax bill? A 1031 exchange can help by allowing you to sell one investment property and buy another without having to pay capital gains tax on the sale.
Just be careful: You must follow IRS rules to avoid a tax hit. And while a 1031 exchange does allow you to avoid paying capital gains tax when you sell and buy investment properties, it doesn't eliminate the tax completely. You'll have to pay up eventually.
Ready to use the 1031 exchange program to boost your investment property holdings? Here are the strategies you need to know.
What Is A 1031 Exchange?
In a 1031 exchange transaction, you can sell an investment property without paying capital gains taxes if you invest the proceeds from your sale into buying another investment property.
However, there are some rules – created the by the IRS – that you must follow. The property you’re buying and the one you’re selling must be "like-kind," which the IRS defines as being of the same nature or character, even if the properties differ in their overall quality. This is good news for investors because it means that most real estate properties are considered in-kind and qualify for a 1031 exchange.
Another key rule: If you’re selling a property in the United States you can only close a 1031 exchange by buying another piece of real estate in the country. If you’re selling a property outside the United States, you can only reinvest your proceeds into another property located outside the country.
Why Should You Use A 1031 Exchange In Real Estate?
Real estate investors, real estate agents and title companies typically turn to 1031 exchanges because of their tax benefits.
When owners sell real estate that has increased in value since they bought it, they typically must pay taxes on the profit they make in these sales. This is the capital gains tax. The amount owners pay depends on their income, tax filing status and how long they owned the real estate.
By participating in a 1031 exchange, owners can avoid paying this tax at the time of sale, which helps to boost their bottom lines.
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How Does A 1031 Exchange Work?
For a 1031 exchange to work, the property you’re selling and the one that you’re buying must be of the same nature as defined by the IRS. For a 1031 exchange, this means that both properties must be real estate investments.
This can give you plenty of leeway. Maybe you’re selling an apartment building. If you then buy a vacant piece of land, the IRS considers that land to be of the same nature as the apartment property you sold. The same holds true if you sell a single-family investment home and use the proceeds from that sale to buy an office property.
Here's an example: Say you've invested in a single-family home in St. Louis for $100,000 and you spent $50,000 renovating this property. You might sell this investment property for $250,000.
You'd then take your profit, or capital gain, of $100,000 and buy another single-family home that you will renovate and sell. You won't have to pay capital gains tax on the profit you earned from selling that first St. Louis investment property as long as you invest them in another piece of real estate.
You can use the 1031 exchange rules to defer paying capital gains taxes until you sell your final investment property and take that profit without investing in another piece of real estate. Once you stop buying new properties, you'll need to pay all the capital gains taxes that you owe.
Types Of 1031 Exchanges
There are several types of 1031 exchanges:
- Delayed exchange: Delayed exchanges are the most common type of 1031 exchanges. To qualify for one of these, you must identify the new property that you want to buy within 45 days of selling your original property. You must then close on the new property within 180 days. You'll report the 1031 exchange by attached a completed Form 8824 when you file your income taxes.
- Reverse exchange: In a reverse exchange, you'll purchase your second piece of real estate before selling the property that you already own. You'll usually have 45 days to identify the property that you want to sell and 180 days to complete this sale.
- Improvement exchange: In an improvement, or construction, exchange, you'll trade a property or properties for vacant or undeveloped land. You can then use the proceeds from the sale of your property to build new real estate on the vacant land.
- Simultaneous exchange: In a simultaneous exchange, the property you sell and the one that you buy both close at the same time.
1031 Exchange Rules
You’ll need to follow certain rules when closing a 1031 exchange, most of them centering around the type of real estate involved and the number of days you have in which to complete an exchange.
The IRS states that you can only complete a 1031 exchange involving like-kind properties. This means that you must swap one form of investment or business real estate with another.
This provides plenty of flexibility. You can swap farmland for an apartment building, rental homes for an office building or an office building for an industrial property.
The main limitation? If you own a property in the United States, you can only swap it for another property in the country. If you own a piece of real estate in another country, you can only swap it for a property in that country.
You must also meet certain time requirements to successfully complete a 1031 exchange. According to the IRS, you must identify the new property that you want to buy within 45 days of selling your original property. You must then close on this new property within 180 days.
1031 Exchange FAQs
Here are some of the most common questions about 1031 exchanges and how they work.
What is a 1031 depreciation recapture?
While you'll avoid paying capital gains taxes when you complete a 1031 exchange, you might still owe income taxes. That's because you might have taken depreciation deductions if you've owned a property for several years. Doing this reduces the property's net adjusted basis, which is its original purchase price plus capital improvements minus depreciation.
If you sell this property for a price that is higher than its net adjusted basis, the depreciation you earlier claimed is recaptured. The gain above your property's net adjusted basis, then, is taxable as income.
You might also pay income taxes depending on how much you spend on your replacement property. That's because any money you have left over from the sale of your property after you buy its replacement property is also taxable as income. This leftover income is often referred to as "boot."
For instance, say the mortgage on your old property was $500,000 and the mortgage on your new one is $400,000. You will owe income taxes on $100,000 of income, otherwise known as this deal's "boot."
Can you do a 1031 exchange for any type of investment property?
The IRS says that you can only do a 1031 exchange between similar properties. Fortunately, the IRS’ definition of “similar” is generous. Basically, you can close a 1031 exchange between any two pieces of investment or business real estate and meet the IRS’ like-kind, or similar, requirement. If you’re selling a property in the United States, though, you’re required to purchase another property in the country. If you’re selling a property in another country, you can only close a 1031 exchange with a property in that same country.
What is the benefit of a 1031 exchange vs. selling the property?
A 1031 exchange allows owners to defer paying capital gains taxes on any profit they make when selling a property because they’re immediately investing these gains into new real estate. This can help investors and owners reduce their tax burden. These capital gains taxes aren’t eliminated, though. They’re only deferred. Owners will eventually have to pay the capital gains they owe after they sell their last property without purchasing a replacement.
The Bottom Line
A 1031 exchange can be an important tool for real estate investors who want to avoid the large capital gains taxes that can come with selling real estate at a profit. But to take advantage of this program, investors need to understand how it works and what guidelines the IRS has set for it. Ready to add to your real estate portfolio? Get started by applying for a mortgage online.