When you’re an investor, you make money knowing when to buy and sell each investment. However, the problem with selling your investment is that you’ll generally owe taxes on the gains you’ve made. This is especially true in real estate where the gains can be substantial over time.
One strategy that could help you defer taxes on the sale of your rental property is a 1031 exchange. Here’s how a 1031 exchange works and what you should know about this option.
What is a 1031 exchange?
A 1031 exchange is a type of real estate transaction where a seller reinvests proceeds from the sale of an asset into a like-kind asset to help defer capital gains taxes. At the most basic level, it involves swapping one property for another of a similar type and value. U.S. Internal Revenue Code section 1031 is the tax code that enables this strategy for owners of investment and business property.
The Tax Cuts and Jobs Act of 2017 redefined the types of investments that qualify for like-kind property exchanges. Prior to this, exchanges of personal property or intangible assets, such as equipment, vehicles, artwork, and patents, could qualify for a 1031. But with the changes, only real property that is held for use in a trade, business, or for investment is eligible for this favorable tax treatment.
Under 1031 rules, real estate investments like a single-family residence, apartment building, or office building could qualify for a like-kind exchange and offer potential tax benefits. However, these benefits typically don’t apply when you buy property for use as a primary residence or vacation home. They also don’t apply to exchanges of inventory, marketable securities, partnership interests, or certificates of trust.
How does a 1031 real estate exchange work?
If you’re considering a 1031 deferred exchange with your upcoming sale, there are rules to follow in order to defer the profits from your sale by investing money in a new property. Here are some rules to be aware of.
1. Choosing a replacement property
When choosing a replacement property, it does not have to be the exact same type as what you sold. However, 1031 exchanges generally make the most sense when the replacement property is of equal or greater value to the property you are selling. Any money that is not reinvested is considered “boot” and is taxable.
If you’re selling a single-family rental, you could reinvest your profits in a duplex, apartment complex, commercial building, storage facility, or any other qualifying property. You could even exchange your rental property for raw land and potentially qualify for a 1031 exchange. The quality or grade of the real estate does not impact your ability to use this strategy.
However, you cannot exchange a property within the U.S. and replace it with one that is in another country.
2. Meeting the 45-day deadline
When exchanging properties through a 1031 exchange, it does not have to be an instantaneous swap. The IRS gives you time to find a replacement property and complete the purchase after you've already sold your property.
Rules for 1031 exchange require that you identify potential replacement properties within 45 days of the sale of your current property. These properties do not have to be under contract to qualify as potential replacement properties. The identification must be in writing, signed by you, and delivered to the seller or the qualified intermediary assisting with the transaction
If your initial replacement property falls through and the 45-day deadline has not passed, you can identify a new property. Once the deadline has passed, you cannot identify any new properties.
3. Working with a qualified intermediary
With most types of 1031 exchanges, a qualified intermediary acts as an exchange facilitator and handles the money, similar to how an escrow company or attorney helps with the sale of your primary residence. Proceeds from a sale are generally held in an exchange fund. This is because the owner of the property being sold cannot take possession of the sale proceeds until an exchange is complete or gains could be taxable.
Administrative fees for qualified intermediaries can range from $600 to $1,200 per transaction, depending on the intermediary you work with. Actual fees may also vary based on the size of the deal, complexity, and where the properties are located.
4. Completing the purchase of replacement property within 180 days
The final step of a 1031 exchange is to complete the purchase of your replacement property. The transaction must close within 180 days of your sale date or the due date for filing your taxes, whichever comes first.
Sale proceeds reinvested under Section 1031 are generally sheltered from capital gains taxes until that property is sold in the future.
Types of 1031 exchanges
Just as there are many types of individual retirement accounts, there are multiple types of real estate exchanges as well. Here are a few of the most common 1031 real estate exchange processes.
This is a rare situation where two property owners exchange properties with each other. It is unlikely that both investors want the other person's property and that the two properties are the same value.
Because the transactions are simultaneous in a two-party exchange, they generally meet the 45-day and 180-day requirements for a 1031 exchange.
- Does not require a qualified intermediary
- Simultaneous exchange
- May be difficult to find a willing exchange partner
A three-party exchange is also a rare situation that allows one person to exchange their property, another to liquidate, and a third to make a purchase.
For example, Mary wants to sell her property, but nobody is willing to buy it. John is willing to exchange his property for hers, but she would rather have the cash. John finds a buyer for his existing property. This allows John to acquire Mary's property and pay her while selling his without paying taxes on his realized gains.
A three-party exchange typically happens simultaneously as well, but there may be delays between the two transactions (Party A buying Party B's property, and Party B using that cash to buy Party C's property). In the event the transaction is not simultaneous, the 45-day and 180-day deadlines still apply.
- Can help multiple people achieve their goals
- Typically a simultaneous exchange
- Can be complicated with three parties involved
- May be difficult to find a willing exchange partner and buyer
This is the most common real estate exchange. The investor sells their property and the proceeds are held with a qualified intermediary. From the date of sale, the investor has 45 days to identify a replacement and 180 days to close on the purchase.
- Can allow time to find a suitable replacement property
- Must pay a qualified intermediary
A reverse exchange is when an investor buys a replacement property before selling their existing property.
The new property must be held in a qualified exchange accommodation arrangement (QEAA) until the sale is complete in order for the investor to receive the 1031 exchange tax benefits. In addition, the relinquished property must be sold within 180 days.
- Allows an investor to buy a replacement property without waiting for the sale of an existing property.
- Investor must be financially able to purchase the replacement property without the proceeds of the sale of the current property.
- The new property must be held in a QEAA until the current property is sold.
Special 1031 exchange rules and considerations
1031 real estate exchanges are complex transactions, but certain circumstances make them even more challenging. When selling a property in one state and buying its replacement in another, the different tax laws and income tax rates of those states can complicate things. It can be a good idea to work with a tax advisor to ensure you are taking advantage of tax mitigation strategies available to you.
In addition to applicable state tax laws, federal tax law requires that investors who sell their buildings account for depreciation recapture. Here’s how it works.
Real estate investors are able to deduct their building's depreciation each year to reduce their taxable income. When a property is sold, there is a process called “depreciation recapture” that essentially reverses those accumulated deductions. This process allows the IRS to collect taxes on a profitable sale. Investors must pay ordinary income taxes on the lesser of the gain on the sale or the accumulated depreciation that has been deducted by the investor over the years.
Let's say you bought a building for $1 million and have accumulated depreciation of $600,000. That results in a cost basis, which accounts for the original market value minus depreciation, of $400,000 for tax purposes. You then sell the property for $1.1 million, which results in a profit of $700,000.
The depreciation recapture rules require that you pay ordinary income taxes of the lesser of the profit ($700,000) or the accumulated depreciation ($600,000). Ordinary income taxes on depreciation recapture are capped at 25%, so the rate is the lesser of their marginal tax rate or 25%. The remaining $100,000 in profit would then be taxed as capital gains.
When you complete a 1031 exchange, you are able to defer both the depreciation recapture and the capital gains owed on the sale.
What happens if a 1031 exchange falls through?
If your deal falls through and a sale is not completed, or if there is a boot, that amount is subject to taxes. Capital gains tax rates are generally lower than ordinary tax rates. For the 2021 tax year, capital gains rates are:
|Capital gains tax rate||0%||15%||20%|
|Taxable income (single filer)||Up to $40,400||$40,401 to $445,850||Over $445,850|
|Taxable income (head of household)||Up to $54,100||$54,101 to $473,750||Over $473,750|
|Taxable income (married filing separately)||Up to $40,400||$40,401 to $250,800||Over $250,800|
|Taxable income (married filing jointly)||Up to $80,800||$80,801 to $501,600||Over $501,600|
These limits are indexed for inflation and are adjusted on an annual basis.
You’ll report the transactions from your 1031 exchange on Form 8824 on your Federal tax returns. The form asks for detailed information, such as property descriptions, identification and transfer dates, gain or loss on sale, and cash received or paid. State laws and forms vary, so consider consulting with a tax advisor to determine which forms are necessary for your tax situation.
Whom is a 1031 exchange best for?
A 1031 exchange is best for investors who want to avoid taxes when selling their investment property by reinvesting in additional real estate investments. Investors who want to purchase other investments, such as stocks, bonds, or collectibles, should not pursue a 1031 real estate exchange. Those investments do not qualify for the favored tax treatment on gains.
Those who want to do a 1031 exchange might want to seek out professionals who have experience completing these transactions. These exchanges can be complex and a simple mistake or missed deadline could derail the entire transaction. Because of this, a 1031 exchange is best suited for experienced investors. However, a newer investor might be able to do one as well, provided that they had the support of experienced professionals.
Alternatives to a 1031 exchange
If a 1031 exchange doesn’t sound like the best option, there are other potential ways to make money in real estate that are simpler.
Exchange into a Delaware Statutory Trust. Investors could get into trouble with a 1031 exchange because they might not find a property to invest in or complete the purchase within the required time frames. With a Delaware Statutory Trust, you could still perform a 1031 exchange, but you are acquiring fractional ownership of an institutional quality building. The managers handle everything, so the investment is generally passive for investors. The downside is that the DST might require a longer holding period. You also don’t have any input on the day-to-day operations of the building.
Invest in a diversified real estate portfolio. Instead of purchasing one rental property, you may want to diversify your risk by investing in a portfolio of rental properties. FinTech platforms like Fundrise allow investors to own a fractional interest in a portfolio of properties with a small minimum investment amount. Diversification could help to reduce your risk and provides a more steady stream of income. However, you might not receive the same favorable tax treatment as owning a rental property directly. Additionally, the fund might be difficult to liquidate until the underlying properties are sold or the fund matures.
What kind of property qualifies for a 1031 exchange?
1031 exchanges are primarily for real estate properties used for business or investment purposes. These include single-family residence rentals, apartment complexes, commercial buildings, raw land, and storage facilities. Properties primarily used for personal purposes, such as your residence or vacation home, generally do not qualify.
Are 1031 exchanges worth it?
Although there are fees and special rules for 1031 exchanges, this type of exchange could be worth it because it might allow you to defer your capital gains tax liability. Investors who want to swap their current real estate property for another one might consider using a 1031 exchange.
How do taxpayers report a 1031 exchange to the IRS?
When filing your federal taxes, you'll use Form 8824 to provide the details of your transaction. Each state is different, so consider speaking with a tax advisor to understand your state's rules.
When you're learning how to invest in real estate, when you sell is just as important as when you buy. A 1031 exchange could help you defer taxes on your realized gains from the sale. By using a 1031 exchange, you could reinvest 100% of your sale proceeds into a new property rather than investing only what is left over after paying taxes on your profits.
Although there are strict rules to follow, the tax benefits can be worth it if you have substantial realized gains or accumulated depreciation. Surrounding yourself with an experienced team and using a qualified intermediary might help you avoid problems and reap the tax benefits.