What is a 1031 Exchange?

by The Family Real Estate Group

Introduction

investment property for rental

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A 1031 exchange is a powerful tool for real estate investors to help them defer the capital gains tax on the sale of one investment property and use those funds to acquire another. It sounds like a great tool for real estate investing, right? It can be, but it's important to understand all the moving parts before attempting to use one.

If you're a real estate investor, or simply curious about a 1031 Exchange, keep reading to get all the info you need.

What is Section 1031?

The term 1031 Exchange gets its name from Section 1031 of the Internal Revenue Code. In the simplest terms, it's the swap of one investment property for another. This allows a real estate investor to change the investment without recognizing a capital gain, which would incur a sizable tax bill.

And because there's no limit to how many exchanges you can perform, you can roll the gain over from one investment to the next without paying tax on the sale until you cash out years later. If used correctly, you'll only pay a single "long-term capital gains rate" which is currently 15% or 20%. And because it's based on income, some lower-income taxpayers may even pay 0%.

To qualify, both properties must be located in the U.S., and most need to be "Like-Kind" exchanges. You can even apply the exchange to former principal residences under specific conditions.

1031 Exchange Timeline and Rules

investment property under construction

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It's not common for an investor to find someone with the perfect property just waiting for you to come along for a swap. It's because of this that most exchanges are delayed which requires the use of a "Qualified Intermediary" - a middleman who holds the funds from the sale of your property and uses them to purchase a replacement property on your behalf.

The 45-Day Rule requires that you designate the replacement property in writing to the intermediary within 45 days of when your property is sold. You may select up to three properties as long as you close on one.

The 180-day Rule requires that you close on the replacement property within 180 days of your sale of yours. Both the 45 and 180-Day Rules run concurrently, so if it takes 30 days to designate the replacement property, you'll only have 150 days remaining for closing.

Buying a replacement property before selling yours is called a "Reverse Exchange" which we'll go over in another article.

1031 Exchange Tax Implications

Most of these tax-deferred exchanges won't be exact dollar-for-dollar matches. If you have available cash left over once your intermediary acquires the replacement property, they'll pay that out to you and the end of the 180-day period. The leftover cash known as "boot" is considered income and taxed as proceeds from the sale of your property in the form of capital gain, usually.

It's also important to factor in mortgage loans or any debt on the property you're exchanging. The $1.25 million mortgage on the new property is lower than the $1.5 million mortgage on your old property - this leaves you with a $250k gain in the eyes of the IRS, and will be taxed as "boot".

Can you do a 1031 Exchange on Vacation Homes?

vacation home for 1031 exchange

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In the past, it was possible to perform an exchange of one vacation home for another, then, later on, make it your principal residence and eventually sell it and shield up to $500k in capital gain if you'd live in the property for only two out of the past five.

That loophole was closed by Congress in 2004, but you can still convert your vacation home into a rental property and perform an exchange. You're required to rent the home to another person for a specified time and limit your use of the home to 10% of the number of days during the specified time.

An important distinction here is that you have to have tenants occupy the property. During this time, the vacation home can't be offered for rent without tenants or the property would be disqualified.

Can you do a 1031 Exchange on a Principal Residence?

principal residence

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Unless you rented your principal residence to someone else for a specified time period without living there, a principal residence won't usually qualify for an exchange.

What about a 1031 Exchange on a second home?

An important distinction to keep in mind is that 1031 Exchanges apply to property held for investment purposes. So a second home or vacation home, wouldn't qualify unless it's rented out for the required time while generating income.

Here's an example of how a 1031 Exchange would work

office space as investment property

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Let's say you own a small office park currently worth $1 million due to its location. Your real estate broker brings another listing to you for a larger office park in another part of town on the market for $1.25 million. While the new property isn't in a popular location, it contains more units in an up-and-coming area which means more rental income and the potential rental rates will increase over time.

You use the 1031 Exchange to sell your smaller office park, and use the proceeds to help pay for the larger office park while deferring the tax liability. You're essentially left with additional funds (the deferred capital gains tax fee) to invest in improvements in your new office park and attract new higher-paying tenants.

The Bottom Line

A 1031 Exchange is a valuable tool real estate investors can use to defer capital gains taxes with unlimited frequency to assist in growing their real estate portfolio. However, the only way to do it successfully is by knowing the ins and outs of how to properly use the exchange or working with real estate agents who do, like The Family Real Estate Group.

I hope you enjoyed reading this post and learning a little bit more about how 1031 Exchanges work. If you have any questions or comments, please leave them in the comments below or get in touch today!