What is a 1031 Exchange

What is a 1031 exchange?

If a landlord decides to sell a rental property at some point, they will need to pay taxes on that gain. Now, this might not be a big deal if the property was a terrible investment or the investor had some bad luck and doesn’t have any financial gain. But in the case of those transactions that do make a profit, Uncle Sam is gonna come a-knockin’ for his piece of the pie.

Don’t fret, though. There is some good news: The IRS wants to partner with investors on that money by allowing a 1031 exchange. This technique is so named because it’s outlined in Section 1031 of the Internal Revenue Code.

A 1031 exchange is a tax strategy so named because of its inclusion in Section 1031 of the IRS tax code. It is also commonly known as a “Starker exchange” or a “like-kind exchange.”

In essence, a 1031 exchange allows an investor to “defer” paying any property taxes on the property when it is sold, as long as another like-kind property is purchased using the profit received.

Tax Cuts and Jobs Act of 2017 changes

Understand that the 1031 exchange is not just for real estate investment purposes—but real estate is the most common use. The Tax Cuts and Jobs Act of 2017 limited these exchanges to “real property,” with some exceptions. The rule now applies “only to exchanges of real property that is held for use in a trade or business or for investment.”

This shouldn’t affect most real estate investors, but it may affect personal property sold with an investment property. It’s important to check with your accountant to determine if your 1031 exchange suits current laws.

Working with the IRS

If the strict rules of a 1031 exchange are followed, the IRS allows investors to hold onto the money and reinvest it in another property. The taxes are still going to be due someday, but until that point, it can be extremely advantageous to keep using the government’s money to invest in properties.

In addition to the government “partnering” with investors, the entire U.S. tax system is designed to encourage certain behaviors in society by rewarding or penalizing people for certain actions. In this case, the U.S. government is rewarding real estate investors for providing housing for the masses.

The benefits of the 1031 exchange

The logical reason for the 1031 exchange makes sense. After all, if an investor makes $100,000 on a property and then uses that $100,000 to buy another property, it’s not like they are out spending $100,000 on shiny new toys. In fact, the money never even touches the investor’s bank account after the sale of the property, but is held by an “intermediary.” So, the IRS in all its benevolence has decided to be fair and not require that taxes have to be paid right now.

Even more than the tax-savings advantages, the 1031 exchange has several other benefits as well. It can allow real estate investors to shift the focus of their investing without incurring a tax liability.

For example, perhaps a landlord is investing in properties that are low-income and high-maintenance. They could exchange the high-maintenance investment for a low-maintenance investment without needing to pay a significant amount of taxes. Or perhaps they want to move their investments from one location to another without the IRS knocking. The 1031 exchange makes this possible.

Now it’s time to illustrate how a 1031 exchange works in the real world.

1031 exchange examples

Here are two examples of how 1031 exchanges can be used to defer taxes on the sales of real estate investments.

Example 1: Apartment building

In July of 2013, the Buyer purchased an 81-unit apartment building for $3.1 million and immediately set out to improve the building.

After increasing occupancy from 60% to 95% and stabilizing the entire operation, the buyer sold the property for $5.5 million in the spring of 2015. for a final profit of $2 million on the two-year apartment turnaround.

Had he simply sold this deal, he would have needed to pay close to $600,000 in capital gains tax. The buyer used a 1031 exchange to parlay his cash into two new properties, a 24-unit apartment building and an upscale office building.

Example 2: Single-family home

In 2012 buyer 2 purchased a newer single-family home for $70,000. The home was a foreclosed property that quickly climbed in value. When buyer 2 sold the home two years later for $135,000, he cleared almost $60,000 in profit.

According to buyer 2 he would have had to pay close to $15,000 in capital gains tax plus an additional $3,000 or so for the recapture of depreciation. Instead, buyer 2 spent $600 on the 1031 exchange process and was able to roll his entire profit into the purchase of a newer, larger single-family home and a mobile home on one acre of land. Essentially, he turned one $1,000-per-month rental into two that gross a combined $1,950.

Buyer 2 also mentioned that this is the most typical 1031 deal that he does. He does not sell a home via 1031 until he has first identified a replacement and then starts marketing the home that has the lowest return on equity (not return on investment). This point is key. It is nearly impossible to source an adequate replacement in the short time period allowed, and the trade is worth it if the replacement is scored at a deep discount, which is rare and takes time.

Buyer 2  maintains a pipeline of turnkey investors ready to purchase the inventory that he wants to sell. He also continues to property manage these homes, which adds another $100 monthly to the gross transaction. When it’s all said and done, Buyer 2 doubles the gross rental income and pays no tax in the process. It’s slow going, but he has used this method at least 15 times and it’s an ideal way to slowly build wealth.

In both Buyer 1 & 2 are simply exchanging their property for another property (or multiple properties) with different individuals.

Related Story: Are 1031’s Going Away

1031 exchange rules

Some pretty strict rules must be followed for a 1031 exchange to get the tax-deferred exchange.

1. Properties must be “like-kind”

The IRS requires that the property being sold (the “relinquished” property) and the property being acquired (the “replacement” property) must be “like-kind assets.” In other words, car dealerships cannot be bought to trade for vacation homes, as they are different kinds of assets.

However, investors can exchange almost any type of investment property for any other type of investment property. You could exchange a duplex for an apartment complex, a piece of raw land for a rental house, or a vacation rental property for a strip mall.

Also, keep in mind that the property must be an investment, not a primary or secondary home. Additionally, both properties must be within the U.S. to qualify.

Finally, sorry house flippers, properties that are designed for a quick purchase and resale do not count.

2. The replacement property should be of equal or greater value

In order to completely avoid paying any taxes upon the sale of a property, the IRS requires that the replacement property being acquired is of equal or greater value than the property being relinquished. However, that value could be spread out over multiple properties.

For example, let’s say a landowner has a real property that they want to sell for $1 million. To get the full benefit of the 1031 exchange, they must buy at least $1 million worth of like-kind real estate through the 1031 exchange. Now, that could be a +$1 million apartment complex or four different +$250,000 properties. It doesn’t matter. (Also note that acquisition costs such as inspections, escrow fees, commissions, etc., do count toward the total cost of the replacement property.)

Technically, it is possible to carry out a partial 1031 exchange and purchase something of lower value, but taxes will have to be paid on the difference. For example, if the relinquished property is being sold for $1 million and the investor purchases a new property through the 1031 exchange for $900,000, they will need to pay the normal capital gains taxes on the $100,000 difference. This extra $100,000 is known as “boot.”

Finally, understand that the sale price of the relinquished property is the entire sale, and not just the profit made. In other words, if a property was purchased for $100,000 and then sold for $200,000, the replacement property would need to be greater than $200,000, not just the $100,000 in profit.

3. The 45-day identification window

The IRS imposes a very strict timeline on identifying the replacement property: 45 days. The investor must identify the property they plan to close on within 45 days or lose the entire benefit of the 1031 exchange. The clock starts ticking on the day that the relinquished property is sold.

Realistically, investors will have more time than just 45 days, as the timer doesn’t start until the day they sell their property. The property will most likely be listed for sale several months before closing, so investors should start looking for deals long before their property is officially sold.

Ideally, the day that the property is listed for sale is the day to begin searching, or as in the story with Serge above, consider selling an asset using the 1031 exchange after finding a new deal to purchase. Keep in mind, investors can also negotiate a long escrow period on the property they are selling, giving them more time before the countdown begins.

In addition to the countdown the IRS places on real estate investors, there are some strict procedures to follow in this process. For example, investors are allowed to officially identify three potential deals, which is helpful in case the first one doesn’t go through. If only one property is identified and something happens later in the due diligence period, the investor might miss out on the entire 1031 exchange. The IRS generally allows up to three potential replacement properties—no more.

There’s always an exception to a rule.

There are a few exceptions to this rule, known as the 95% rule and the 200% rule. The first of these exceptions states that more than three properties can be identified, but the investor is required to purchase 95% of those identified. The second is that the total combined cost of all those identified properties is less than 200% of the sales price of the relinquished properties.

For example, if an investor formally identifies 20 different potential properties, they would either have to end up purchasing 19 of those—95% of the 20. Or the combined value of all 20 would need to be less than 200% of the sale price.

So what exactly does it mean to “identify” a property? According to the IRS:

“The identification must be in writing, signed by you, and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.”

Once the properties have been identified, it’s time to move toward closing on those properties because another timer has already begun ticking…

4. The 180-day closing window

At the same moment that the 45-day window to identify a replacement property starts, another clock begins counting down too. It’s known as the 180-day closing window.

The IRS requires that the new replacement property be fully purchased (the title officially transferred) within 180 days of the sale of the relinquished property. This rule, along with the 45-day rule, is strictly enforced. The entire 1031 exchange will fail if both rules are not met.

5. No touching

Finally, one of the most important rules governing the entire 1031 exchange process is this: The investor cannot touch the money of the relinquished property if they hope to avoid the taxes.

Although there may be up to 180 days in between the sale of the relinquished property and the purchase of the replacement property, the proceeds may never enter the investor’s bank account or an account controlled by the investor. Instead, they are required to use a qualified intermediaryAn intermediary is someone who holds onto the money while the investor waits to buy the new property.

A quick Google search will yield a result of hundreds of companies that can serve as a qualified intermediary, also known as an accommodator. Investors should choose an established company that has a long history and solid reputation to avoid fraud or other unfortunate situations.

Also keep in mind, while the IRS doesn’t specifically state what a qualified intermediary is, they do define what a qualified intermediary is not. A qualified intermediary cannot be the investor, their agent, their broker, their spouse, their family member, their investment banker, their employee, their business associate, or anyone who has had one of these roles in the past two years.

The 10-step 1031 process

Below is the step-by-step process to carry out a 1031 exchange. The following is just a general outline, so specific deals will likely vary slightly from this process.

1. Decide to sell and do a 1031 exchange

Not every purchase is worth doing a 1031 exchange. After all, with all the requirements, costs, and countdown timers, it may be advantageous to simply pay the tax and move on. That is definitely a discussion to have with an accountant or tax adviser.

2. List the property for sale

The property for sale will be listed and the agent will likely include language in the listing paperwork regarding the seller’s desire to do a 1031 exchange and the buyer’s needed willingness to go along with the process.

3. Begin looking for replacement properties

Remember, the moment the relinquished property is sold, the countdown of 45 days begins. Therefore, the investor should begin looking for deals immediately.

4. Find a qualified intermediary

The investor needs to look for someone professional with a good reputation.

5. Negotiate and accept an offer

When someone agrees to buy the property, the paperwork must clearly state that a 1031 exchange is taking place on the seller’s end and the buyer will need to comply. Although there is not a lot of work for the buyer to do, there may be paperwork they need to sign off on, such as assignments or disclosures.

6. Close on the sale of the relinquished property

The title company or attorney will handle the closing like any other real estate transaction, except the seller’s qualified intermediary will be actively involved in the process. And the funds will transfer to the intermediary’s bank account, not the sellers.

7. Identify up to three properties within 45 days

It’s now time to officially designate the properties that are under consideration. Keep in mind, up to three properties can be identified, but buyers are required to purchase 95% of the identified properties—or the total combined value of the identified properties is less than 200% of the sales price of the relinquished property.

8. Sign contract on the first-choice property

Most likely, of the three properties identified, one will stand out as the first choice. The buyer will need to get that property under contract and open escrow, making sure the seller knows that the purchase is through a 1031 exchange. Buyers can also go under contract on all three of the identified properties and use contingency clauses to back out on the properties the buyer chooses not to pursue.

9. Let the qualified intermediary work with the title company

The buyer, agent, and qualified intermediary will work with the title company or closing attorney to make sure all the i’s have been dotted and t’s have been crossed. This is a fairly simple process that any qualified intermediary should be familiar with.

10. Close on the replacement property

Finally, the qualified intermediary will wire over the money to the title company or attorney. The property will close like a normal transaction, deferring the buyer’s need to pay the taxes until some point in the future, if ever. (Read on to find out more about the “end game” in a moment.)

The beauty of the 1031 exchange is the ability to repeat this process over and over again on properties and continue deferring taxes indefinitely. This can help build some serious wealth over time, greater than simply paying the taxes each time. One of the greatest benefits of the 1031 exchange is faster wealth growth.

How this strategy can make you millions

Below are timelines for two different investors who bought and sold properties over a 35-year span. The investors in both scenarios start with the same amount of money ($50,000), buy the same property (a $250,000 deal), have the same growth (5% equity growth each year), and reinvest their profits as a 30% down payment on their next deal, but end up with a very different amount due to the taxes. Take a look.

For simplicity’s sake, closing costs, depreciation, loan pay-down, cash flow, and other obvious sources of income and expenses in this diagram are not included. This is simply to illustrate a point.

Years Purchase price Sold for Profit Equity to reinvest
1 to 5 $250,000 $319,070 $69,070 $119,070
6 to 10 $595,352 $759,837 $164,485 $283,555
11 to 15 $1,417,776 $1,809,481 $391,705 $675,260
16 to 20 $3,376,302 $4,309,112 $932,810 $1,608,071
21 to 25 $8,040,353 $10,261,754 $2,221,401 $3,829,427

Investor one above purchased a $250,000 property with their $50,000 down payment. After five years, they sold it for $319,070.39. They were able to use the entire profit—and their equity built thus far—to put a 30% down payment on their next deal. This continues for 25 years with no tax due because of the continual use of the 1031 exchange. Now let’s take a look at investor two, who chose not to use the 1031 exchange.

Note: The profit to reinvest is after paying 15% taxes.

Years Purchase price Sold for Profit Profit to reinvest
1 to 5 $250,000 $319,070 $69,070 $108,710
6 to 10 $543,549 $693,722 $150,172 $236,357
11 to 15 $1,181,783 $1,508,288 $326,505 $513,886
16 to 20 $2,569,428 $3,278,314 $709,886 $1,117,288
21 to 25 $5,586,442 $7,129,873 $1,543,431 $2,429,205

After 25 years, investor two ended up with just under $2.5 million. While still a respectable sum of money, notice that they trail investor one by more than $1 million! This is because investor one was able to put the government’s money to work, helping them build greater wealth.

Now, what happens at the end of year 25 to investor one? After all, the 1031 exchange is simply a method of tax deference for taxpayers, not tax avoidance. Or is it?

The end game

In the example above, investor one ended year 25 with $3.8 million, while investor two ended with $2.4 million. But what happens after that? Typically, there are three common scenarios for any real estate investor when they are finished with their investment career.

1. Cash out

Some investors decide to get out of the real estate game entirely, cashing in their chips and walking out the door. In other words, they decide that they will pay the IRS what they owe after selling all their properties. However, at this point, they are not simply paying the taxes on that final property’s profit, but (put very simplistically) on all the properties they have ever used the 1031 exchange to avoid.

Because the “cost basis” of the property is carried forward on every deal, that final tax bill will likely be exceptionally large. However, because they were able to continually use the government’s money to buy larger and larger properties, even cashing out and paying the taxes will put investors far ahead of where they would have been by paying the tax each time.

However, investors probably do not want to pay that tax if they can avoid it. And, yes, there is a way to avoid paying taxes—forever!

2. Die and pass it on

That’s right, many investors simply choose to hold onto their properties until the day that they die, passing on the properties to their heirs. The benefit of this is that current inheritance laws allow the heirs to receive the property on a “stepped-up basis,” which means the tax consequences virtually disappear.

For example, let’s say the adjusted basis on a property, after numerous 1031 exchanges and lots of time, is $200,000 and the property is worth $3 million. If the owner sold the property five minutes before death, they would owe taxes on the $2.8 million in capital gain taxes. But if the estate passes to the heirs, the basis automatically is bumped up to the fair market value, or $3 million. The heirs could then sell the property and pay little, if any, tax. Of course, there are special rules and fine print that accompany this (especially for the exceptionally wealthy), so a qualified professional must be talked to about estate planning.

Of course, not every investor wants to hold onto properties until they are on their deathbed. So how do landlords get around this?

3. Trading up

By trading up into properties that are significantly easier to manage.

For example, a property’s equity can be used for a 1031 exchange of a multimillion-dollar shopping mall as part of a syndication with hundreds of other investors. Or trade into a triple net (NNN) lease investment, where the tenant pays everything and the landlord sits back and collects a check. Trading up to a more passive method is one of the hundreds of ways to make money with real estate.

A 1031 exchange may be slightly complicated, but the long-term benefits of using this tax loophole can pack a tremendous punch in future wealth creation and should be considered by all serious real estate investors who are in this game for the long haul. Remember, a qualified tax professional should always be consulted first before deciding to start the 1031 process. It may not be for everyone but, hopefully, this road map can help you decide if a 1031 exchange is a worthy endeavor.