What is a 1031 Exchange?

Whether you are still fairly new to real estate investing and own only one property, or you’ve been in it a while and have built up a portfolio, one beneficial strategy for tax deferment and leveling up is what’s known as a 1031 exchange. When properly utilizing a like-kind exchange to trade properties, you aren’t required to recognize a financial gain under Internal Revenue Code Section 1031. And an exchange can be considered “like-kind" just as long as you are purchasing a property (or properties) of equal or greater value, and you are exchanging investment property for investment property. A primary or secondary home could not be part of this equation.

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For example, you could purchase your first small rental house for $320,000, sell it two years later for $410,000, and pay zero capital gains on the profit, just as long as you put that money right back into another investment property: a duplex; a farm; a small retail center; two rental houses with a combined price that exceeds the sale price of the relinquished property; a commercially zoned home, etc. And when you later turn around and sell the replacement property, you can do the same thing again, kicking the tax bill down the road over and over until you finally move on to that great pearly-gated community in the sky.

The Rules

First and foremost, hands off the money. You cannot hold on to the proceeds from the sale of property #1, while you wait to purchase property #2. If you do, then you can kiss the opportunity for a 1031 exchange goodbye. Instead, you must place the funds with what’s known as a “qualified intermediary”: usually an accountant or attorney, who holds onto the funds until they go directly toward the purchase of the replacement property.

Second, there is a ticking clock. This starts upon the sale of property #1, and you have 45 days beyond closing on the relinquished property to identify up to three like-kind properties that could take its place.

Another deadline that’s triggered upon relinquishing property #1 is a 180-day period for closing on the replacement property. And just as the 45-day ticking clock is strictly enforced, this one is as well.

Finally, both the relinquished property and the replacement property must be located in the U.S. So, no trading for an Airbnb in Italy unfortunately. You’ll have to find something with similar appeal on this side of the pond.

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The Exceptions

What’s known as the 200% rule allows one to identify more than three replacement properties, just as long as the combined value of said properties does not exceed 200% of the sale price of the relinquished property.

And then the 95% rule allows more than three replacement properties to be identified and the combined value can exceed 200% of the relinquished property’s value, but 95% of these properties must close. So, more ability for inclusion, but pretty tricky to pull off. In other words, you could identify four properties, instead of just one from a pool of three candidate properties, to take the place of the small rental house from the first example (let’s say each has a price of $400,000), but if you didn’t close on all four, the deal would not qualify for a 1031.

It is crucial for all the rules and exceptions to be followed very strictly if a seller wishes to take advantage of the tax benefits of a 1031 exchange. Current tax law allows for this process to be repeated multiple times during an investor’s life, and if the properties are owned at the time of death, then the tax bill never comes due. The beneficiary of the properties receives them with a “stepped-up basis,” meaning the new owner could sell them immediately and pay little or no taxes.

Using a 1031 exchange is a strategic process, and obviously it behooves the seller to get an agent involved early, well before closing on property #1, so that he or she can be actively assisting in identifying those replacement properties. And one should always consult with a CPA and attorney at important points throughout the process, and if not certain whether a like-kind exchange is even the best way to go, then check with your financial planner before beginning any other due diligence.

A 1031 like-kind exchange is one tool in an investor’s tool belt that can provide an opportunity to maximize gains and really expand a portfolio. It’s also one of Uncle Sam’s best ways for spurring investment in real estate.