As a real estate investor, being able to defer or potentially eliminate capital gains tax on the sale of investment property can supercharge your returns. Utilizing a 1031 exchange allows investors to rollover capital gains from one investment property into another of equal or greater value, deferring any tax owed. This tax break incentivizes reinvesting proceeds to continue growing your real estate portfolio.
In this comprehensive guide, you’ll learn:
With proper planning, a 1031 exchange can unlock huge savings compared to selling outright and paying capital gains tax immediately.
How 1031 Exchanges Defer Capital Gains Tax
When you sell an appreciated investment asset like real estate, you owe capital gains tax on the profit. With a 1031 exchange, you defer paying those capital gains taxes by reinvesting the proceeds from the sale into a replacement property of equal or greater value within 180 days.
As long as you follow the IRS rules, you can continue deferring taxes on gains indefinitely through successive exchanges into new properties over many years. However, at some point when you sell and don’t reinvest, the accumulated deferred gains will be taxed.
The tax liability is deferred, not completely eliminated. But deferring gains allows you to continue compounding returns on the full investment amount through new acquisitions.
1031 Exchange Examples
Here are some examples to illustrate how investors can put 1031 exchanges to work:
Scenario 1: Moving up in value
John owns a rental house valued at $200,000 with a cost basis of $75,000. He sells the house for a $125,000 capital gain and does a 1031 exchange into a $350,000 rental apartment building. He defers tax on the entire $125,000 gain by reinvesting in the more expensive replacement property.
Scenario 2: Consolidating into one property
Margaret owns two rental condos worth $150,000 each that she wants to combine into one larger property. She sells Condo A for a $50,000 gain and Condo B for a $75,000 gain, totaling $125,000 of gains. She purchases a $300,000 fourplex through a 1031 exchange so the full $125,000 liability is deferred.
Scenario 3: Diversifying a portfolio
David wants to diversify his portfolio of primarily residential rentals into some commercial real estate. He sells a house for a $30,000 gain and a condo for a $45,000 gain, totaling $75,000 of capital gains. He reinvests the proceeds into a retail shop property through a 1031 exchange, deferring the $75,000 tax obligation.
These examples demonstrate how investors of different experience levels can leverage 1031 exchanges to move into larger, more expensive properties, consolidate holdings, or diversify their portfolio mixes while enjoying major tax advantages.
1031 Exchange Qualifications and Requirements
To qualify for tax deferral, 1031 exchanges must meet specific IRS requirements:
Only investment property can be exchanged - A personal residence or second home does not qualify for a 1031 exchange as only investment real estate held for lease, resale or development is eligible.
Replacement property must be identified within 45 days - You have 45 days from when you sell the relinquished property to officially identify possible replacement properties to your qualified intermediary.
Purchase must be completed within 180 days - You have a maximum of 180 days from the sale of the original investment property to close on a replacement property to complete the 1031 exchange.
- Values must be equal or greater - The value of the replacement property must be equal or greater than value of the property sold to defer the full capital gains tax obligation. Any unused proceeds can be withdrawn tax-free.
Title exchange must use a qualified intermediary - To maintain separation, the proceeds from the sale cannot be directly controlled by the investor, but must flow through a qualified intermediary to handle the exchange.
Following these guidelines ensures the transaction complies with the IRS Section 1031 technical requirements.
Maximizing the Benefits of 1031 Exchanges
While 1031 exchanges offer major tax advantages, you can maximize the benefits further with strategic planning:
Transaction order matters - Selling the relinquished property first allows for more flexibility in finding an optimal replacement property to invest in.
Buyers add complexity - Learn contingency plans if selling to an owner-occupant buyer versus an investor who may be open to a delayed closing.
Research before identifying - Use the 45-day identification period wisely to research options before naming specific replacement properties.
Know the local markets - Work with professionals familiar with each geographic market that you are exchanging in and out of.
Be ready to act - Liquidity and decisiveness are key to executing quickly during the exchange.
Improve cash flow - Seek upside opportunities in the replacement property through value-add renovations or new management.
With the right approach, you can utilize 1031 exchanges to accumulate real estate while deferring taxes for years.
What Properties Qualify for a 1031 Exchange?
Virtually any type of investment real estate can qualify for a 1031 exchange as either the relinquished property being sold or the replacement property being acquired. Common examples include:
Residential rental properties - Single-family homes, condos, duplexes, apartment buildings
Commercial real estate - Office buildings, retail centers, industrial warehouses, land
Special use - Hotels, self-storage facilities, seniors housing, etc.
Vacant land - Raw land, permitted lots intended for development
The relinquished and replacement properties do not have to be the same asset class. You can exchange a rental house for an apartment complex or farmland for a retail mall. However, you cannot exchange into your primary residence or second home.
How to Structure Payments in a 1031 Exchange
When selling investment real estate, some proceeds may go towards paying off mortgages, loans, or fees. Here is how to handle payments properly in an exchange:
Mortgage payoffs - Any relinquished property loans must be paid directly from escrow, not by the investor.
Loans on replacement property - New loans should be secured by and funded directly to the recipient entity at closing.
Fees - Exchange-related fees are built into closing costs at purchase of the replacement property.
Cash proceeds - Any leftover cash after the exchange must be returned by the intermediary. Investors cannot receive cash directly without tax consequences.
Proper payment structuring preserves the tax-deferred status. Consult experienced real estate attorneys and CPAs to ensure compliance.
How are Deals Reported to the IRS in a 1031 Exchange?
There are important tax reporting requirements on both the relinquished property sale transaction and the 1031 exchange:
Relinquished Property Sale:
Form 8949 - Report sale of investment property, exclude 1031 exchange gain
Schedule D - Report capital gain/loss amounts with 1031 indicated
Form 4797 - Report investment property sale details
Form 8824 - Provide exchange details including value and basis info
Form 1040 - Indicate that a 1031 exchange was done for any given tax year
It's important to work closely with a tax professional to ensure all reporting done correctly. Maintain thorough documentation in case of any IRS inquiry.
Frequently Asked Questions on 1031 Exchanges
Here are some common investor questions on navigating 1031 exchange transactions:
How much does a 1031 exchange save in taxes?
The amount saved equals the capital gains tax that is deferred. With a federal tax rate of 15% on capital gains and state taxes on top, total savings of 20% or more are common.
Can you do a partial 1031 exchange?
Yes, some proceeds can be withdrawn with gains taxed while the balance goes into the replacement property purchase to defer some tax obligation.
Do 1031 exchange add time to a property sale?
The identification period and exchange timeline do add 45-180 days to fully close out a transaction. However, the massive tax savings generally make it very worthwhile.
Can you exchange into property outside your state?
Yes, it is perfectly allowable to use a 1031 exchange to invest in real estate located in another state, such as moving from property in California to property in Texas.
Does a 1031 exchange require a business entity?
No, exchanges can be done as an individual taxpayer investing in personal name. However, using an LLC, trust or other entity does provide liability protection.
Putting the 1031 Exchange Into Practice
With the potential for major tax savings, a 1031 exchange is a powerful wealth building tool for real estate investors. However, the rules around properly structuring an exchange transaction can be complex. If you are considering completing a 1031 exchange, the knowledgeable advisors at United Tax can help guide you through the process. Our CPAs and attorneys specialize in making exchanges efficient, compliant, and structured to maximize your tax advantage. We stay up to date on the latest IRS regulations and can ensure your exchange meets all requirements. Don’t leave potential tax savings on the table. Contact United Tax today to discuss how we can help make your next 1031 exchange a smooth and lucrative investment transaction.
