Investing in real estate may offer steady passive income, as well as unique tax advantages. But strong real estate appreciation means that the sale of an investment property can come at a big tax cost. Depending on the holding period of the property and whether depreciation deductions have been taken, gains can be taxed at ordinary income rates.
If you would prefer to defer taxable gains, you may be able to benefit from a powerful tax-deferral strategy known as a 1031 exchange. Since this is a highly complex strategy with the potential for significant tax consequences, you’ll need help from a qualified real estate or tax attorney.
What is a 1031 exchange?
A 1031 exchange is a way for real estate investors to sell a property and reinvest the proceeds in a similar (or “like-kind”) property, deferring capital gains taxes that would otherwise be due upon the sale. It is named after Section 1031 of the IRS tax code and is also known as a “like-kind exchange.”
While a 1031 exchange does not eliminate taxes on investment property gains, it delays the tax burden, which can allow you to invest in higher value properties and continue growing your equity. But it’s important to keep in mind that a 1031 exchange is a complex maneuver. To ensure the exchange qualifies under Section 1031, you must follow a strict set of rules, and work with a qualified intermediary (QI), an independent third party responsible for holding the funds and handling the documentation involved in the transaction.
How a 1031 exchange works
The basic structure of a 1031 exchange involves several key steps:
- Sale of the investment property: You’ll likely want to sell a property that has significantly appreciated in value to take full advantage of the tax deferral. As the seller, it’s critical that you don’t receive any proceeds from the sale; instead, all funds must be directly transferred to a QI. If you touch the money at any point in the sale, it won’t qualify as a 1031 exchange.
- Identification of a replacement property: Within 45 calendar days of the sale of the original property, you must identify potential replacement properties. The IRS allows up to 3 properties to be identified, regardless of value, or more under certain valuation guidelines.
- Acquisition of replacement property: You’ll need to close on the purchase of one or more of the identified properties within 180 calendar days from the date of the sale of the relinquished property.
In general, states respect the federal 1031 exchange rules for tax deferrals, but each state may have its own state-specific rules. Once again, it’s necessary to consult with a tax professional.
A 1031 exchange can also be valuable in preserving the ability for beneficiaries to profit from your real estate investments. A beneficiary who inherits real estate can step up the cost basis to the current fair market value on the date of the previous owner’s death. This means if your beneficiary sells the inherited real estate at the same fair market price, there will be no capital gains on the sale, essentially eliminating the taxable gains deferred by the 1031 exchange.
The rules of a 1031 exchange
To benefit from a 1031 exchange, you must adhere to some important rules:
- Like-kind property requirement: The properties involved in the exchange must be of “like-kind,” which usually means real property, held for investment or business use. Any type of property generally qualifies, so you could, for example, exchange a rental house for a commercial building.
Properties used primarily for personal use, such as a primary residence or a second home, do not qualify for a 1031 exchange. Real estate investment trusts, or REITs, also do not qualify for a 1031 exchange, since the IRS considers them personal property.
- Strict timelines: You have 45 days from the sale of the original property to identify replacement properties and 180 days to complete the purchase. These deadlines are rigid and cannot be extended.
- Same taxpayer rule: The name on the title of the relinquished property must match the name on the title of the replacement property. This ensures continuity of ownership.
- Equal or greater value rule: To fully defer capital gains taxes, the replacement property must be of equal or greater value than the relinquished property, and all of the proceeds must be reinvested. If there is any cash left over after the exchange (known as "boot"), it will be taxable as a capital gain. Also, if there’s a discrepancy in debt—say, your old property had a larger mortgage than the new property—the difference in liabilities is treated as boot and taxed accordingly.
- Use of a qualified intermediary: You cannot receive the sale proceeds directly. A QI must hold the funds and facilitate the exchange.
Pros and cons of a 1031 exchange
A 1031 exchange is best suited for real estate investors looking to grow or reposition their portfolios without triggering an immediate tax liability. Below are some reasons to consider a 1031 exchange:
- It may allow you to upgrade to a more valuable property without losing equity to taxes.
- It may allow you to diversify your real estate holdings across markets or property types.
Real estate holdings can potentially increase in value, which may lead to a step-up in basis for your heirs. The main downsides to a 1031 exchange are the complexity and the potential for tax consequences if the rules aren’t followed carefully.
Recent updates to 1031 exchange rules
The 2017 Tax Cuts and Jobs Act (TCJA) made several updates and clarifications to the 1031 exchange rules:
- Restriction to real property only: Prior to 2018, 1031 exchanges could be used for personal property, such as artwork, machinery, or equipment. The TCJA limited 1031 exchanges strictly to real estate.
- Clarification on “like-kind” definition: Recent IRS guidance has reinforced the broad interpretation of “like-kind,” allowing exchanges between different types of real property—such as raw land for a commercial building—as long as both are held for investment or productive use in a trade or business.
The bottom line on 1031 exchanges
A 1031 exchange can be a potential strategy for deferring capital gains taxes and preserving investment capital which may allow you to grow your real estate portfolios. However, this type of transaction is a complicated strategy with many rules. If you’re interested in a 1031 exchange, consult with a lawyer and tax advisor to discuss whether it might make sense for your situation.