§1031 Exchange Guide for Real Estate Investors, 2020 Edition

Some of the most successful real estate investors in the country use §1031 exchanges, also called Starker exchanges or like-kind exchanges, as a tax deferral strategy. 2020 is an excellent time to exchange properties because prices have surged past the so-called real estate bubble prices of the past decade. 

This means that with a successful §1031 exchange, you can essentially trade property in an expensive market for one or multiple properties in other up-and-coming areas of the country, without incurring federal income taxes at the time of the swap.

So, in this article, we will provide a comprehensive guide to §1031 exchanges, including what they are, how they work, the various types and rules that apply, when to do an exchange, and which states have the best §1031 exchange markets currently. At any time you have a question or want to get started, you either call us or request a specialist to call you.

What is a §1031 Exchange

Section 1031 of the Internal Revenue Code (To IRS.gov) details how a §1031 exchange works. Essentially, it allows an investor to defer the payment of federal income taxes typically incurred by selling an investment property, so long as the profit from the property sale is used to purchase a ‘like-kind’ property. The words “like-kind” refer to the nature or character of the property and not to its grade or quality.

This type of exchange provides benefits beyond the obvious financial benefit of tax deferral – it allows you to relocate your investment from properties in one part of the country to another area without trouble from the IRS, and you can switch from high-maintenance to low-maintenance investment properties without a massive tax hit.

§1031 Exchange Requirements

The original premise of a §1031 exchange was that one property would be swapped directly for another ‘like-kind’ property. But, it’s very unlikely to find someone who owns a property that you want, who also wants the property that you own at the same time. Fortunately, the tax code also allows for delayed, reverse, and other types of exchanges that are more practical and easier to achieve.

Top 1031 Exchange FAQs

Here are the top three 1031 exchange questions and answers. To view an even larger list, please visit our FAQ page.

By utilizing a 1031 Exchange an investor is able to defer that capital gains taxes owned by utilizing the funds from the sale of their existing investment property to exchange into the purchase of a new one. There are guidelines that an investor must adhere to, but a 1031 Exchange is one way to defer capital gains tax. Read more how a 1031 exchange works.

There are many rules to a 1031 Exchange, but the most critical ones are the deadline rules.  

      1. After the sale of your property, you have 45 days to identify one or more property you would like to exchange into.
      2. Within 180 days of your sale, you must complete the exchange or incur capital gains tax

Read more about 1031 exchange rules.

In a reverse 1031 Exchange, an investor first purchases the property he wants to trade into before selling his current property. Read more about reverse exchanges and the other types as well.

Watch this 2-minute video explaining how typical 1031 exchanges work using real examples.

How Does a §1031 Exchange Work?

In order to fully demonstrate how §1031 exchanges work, we need to look at the four main types of exchanges and the usefulness of each one.

Delayed §1031 Exchange

Delayed §1031 exchanges are perhaps the most popular because they provide an extended timeframe in which the exchange can be completed. With this type of exchange, the property investor first arranges the sale of their original property and then buys the replacement property afterward.

The investor must market the initial property, secure a buyer, negotiate a purchase agreement, and execute a sale, all before even initiating the delayed exchange. Once those steps have been completed, the investor is then responsible for hiring a third party qualified intermediary. The qualified intermediary then holds the proceeds of the sale for up to 180 days in a binding trust, while the investor finds and acquires a like-kind property to complete the exchange.

With this type of exchange, the investor has up to 45 days to choose a replacement property and 180 days to complete the entire exchange. The time frame in which a delayed §1031 exchange is very strict and must be adhered to or it could disqualify the exchange from favorable tax treatment. This takes some pressure off the deal and allows the investor to sell while the market is in their favor and then take some time to select the best possible replacement property or properties.

Reverse §1031 Exchange

A reverse exchange or forward exchange happens in the exact opposite order from a delayed exchange. With this type of exchange, the investor buys a replacement property first through an exchange accommodation titleholder and sells his or her original (or relinquished) property afterwards.

While theoretically simple, reverse exchanges can be a bit trickier to execute. The investor is required to use all cash for the purchase, and many banks do not offer loans for reverse exchanges. If the investor does not close on the relinquished property within 180 days of purchasing the replacement property, the exchange will not qualify and federal income taxes could be due on the sale.

Simultaneous §1031 Exchange

A simultaneous §1031 exchange requires that both the relinquished and replacement property close at the same day and time. Even a slight delay caused by the money transfer process or some other hindrance can disqualify the exchange and result in the federal income taxes potentially being owed on the disqualified exchange.

There are three different ways to go about a simultaneous exchange. First and most simply, there can be a two-party swap of deeds between the owners of the two properties. Next, there can be a three-party exchange that is facilitated by an accommodating party. Finally, there can be a simultaneous exchange through a qualified intermediary.

Construction or Improvement §1031 Exchange

This type of exchange allows an investor to make improvements on the replacement property using the equity from the sale of the relinquished property, while a qualified intermediary holds the deed of the property in trust for up to 180 days. Three requirements must be met for this type of exchange: 

  1. the entire equity amount must be spent as down payments for improvements or on completed construction or improvements by the 180th day from the initiation of the exchange. 
  2. You must receive “substantially the same property” as what you identified on the 45th day as your replacement property, and
  3. The replacement property must be of equal or greater value when the investor receives the deed back from the intermediary after 180 days. The improvements must already be in place before you can receive the deed from the qualified intermediary.

§1031 Exchange Examples

The overall goal when investing in real estate should be to exchange high-value investment properties for cash flowing turn-key investment properties in the strongest markets around the United States. A §1031 exchange is the perfect vehicle to achieve this goal.

Case Studies

§1031 Exchange Timeline

In its entirety, a §1031 exchange can take no longer than 180 days, or about six months. As we’ve mentioned above, once you initiate a §1031 exchange, you have 45 days to identify potential replacement properties, and then 135 days after that to complete the purchase of one or more of those properties.

steps in a 1031 exchange timeline

Calculate Your 1031 Exchange Due Dates

Use our 1031 Exchange calculator to find out your 45-day and 180-day windows are.

1031 Exchange Rules

There are 6 primary §1031 exchange rules that must be met for a successful tax deferral. Let’s look at what each rule entails:

1. Like-Kind Property

The relinquished and acquired properties must be like-kind properties, which means that they must be similar in nature or character, although they can differ in quality or grade. As it applies to real estate, almost any type of property can be exchanged with nearly any other type. 

For instance, as long as both or all properties involved are located within the United States, apartment buildings, duplexes, single-family rental property, commercial office building the rental property, vacation homes (rentals), and restaurant space rental properties can all be exchanged with each other since they are all essentially the same asset. This also means that you can exchange one large property for several smaller ones and vice versa. Please be advised that there are certain rules that apply for exchanges of one property for multiple replacement properties.

2. Investment or Business Properties Only

§1031 exchanges can only involve investment or business properties Personal properties such as a primary residence do not qualify. Also, personal property in general no longer qualified for tax deferral under §1031 due to the Tax Cuts and Jobs Act of 2017 (to TaxFoundation.com)

3. Greater or Equal Value Property Only

To have 100% of the federal income taxes deferred in exchange, the replacement property needs to have a net market value and equity that’s equal to or greater than that of the relinquished property. 

So for instance, if your property is worth $1,000,000, you would need to select a replacement property that is worth at least that much, or a combination of properties whose total value equals or exceeds $1,000,000.  You can choose to have more than one replacement property as part of your §1031 exchange, so long as their values add up to no more than 200% of the value of the relinquished property value. This is known as the ‘200% rule’ within the meaning of Treas. Reg. §1.1031 (to Cornell.edu).  

It should also be noted that the replacement properties’ values will have no effect on the qualification of tax-deferred treatment under §1031 if no more than three like-kind properties are identified as replacement property.  This is known as the “three property rule.” Acquisition costs such as inspector and broker fees can also be factored into the total cost of the new property or properties.

4. ...Or You’ll Pay Taxes on the “Boot”

You can choose to do a partial §1031 exchange, where the property you relinquish is worth more than the replacement property, but you will have to pay federal income taxes on the difference, which is also called the “boot.”

For example, if you sell a property for $1,500,000 and want to exchange it for a property that’s worth $1,000,000, you would pay the standard amount of applicable federal (and state) income taxes on the $500,000 difference. In this situation, the ‘boot’ would be subject to capital gain rates.

The capital gains tax rate depends on your income tax bracket,as well as how long you held the investment property, and can be 0%, 15%, or 20%. The tax bracket requirements change each year to adjust for inflation, but for married couples who make more than $80,000 but less than about $500,000 per year, the capital gains rate will most likely be 15%.

5. Same Taxpayer Name

The name on the tax return and the title of the relinquished property must match the name on the purchasing documents for the replacement property. The only exception to this rule is if you use a single-member limited liability company (SMLLC) (To IRS.gov) to sell the relinquished property and your individual name to purchase the replacement property. SMLLC is disregarded for federal income tax purposes.

6. TIme Requirements

The name on the tax return and the title of the relinquished property must match the name on the purchasing documents for the replacement property. The only exception to this rule is if you use a single-member limited liability company (SMLLC) (To IRS.gov) to sell the relinquished property and your individual name to purchase the replacement property. SMLLC is disregarded for federal income tax purposes.

45-Day Identification Window

Once you close the sale of your relinquished property, you have 45 days to identify three potential like-kind properties for replacement.

180-Day Purchase Window

Once you’ve sold your relinquished property, you have 180 days to close on the purchase of the replacement property. This is not in addition to the 45-day window period – both periods elapse from the date of sale of the relinquished property, so you have 135 days after the 45-day identification window to complete the purchase of a replacement property. There is one exception to this rule which has to do with the due date of your federal income tax return.

There are a few other things to keep in mind when considering a §1031 exchange beyond these seven rules. For instance, do not plan to take this process on yourself – you need to hire a qualified intermediary to ensure the process is completed properly. Also, although the exchange fees vary state to state, you can expect to pay somewhere between $800 and $1,200 for a standard exchange.

When To Do a §1031 Exchange?

The best time to do a 1031 exchange is when you are in a high tax bracket that would require you to pay a high percentage of federal income taxes, but you want to keep cash on hand in order to keep reinvesting and expanding your real estate portfolio. By deferring the federal income taxes on new properties, you aren’t giving an extra-large portion of your investment capital to the government each year.

There is no limit on the number of §1031 exchanges you can do, so you can keep investing and swapping properties for as long as you like, and then only pay taxes once when you sell your properties for cash. It is also important to consider the attractive nature of §1031 exchanges for estate planning.

When Not To Do a §1031 Exchange?

If you are in a very low tax bracket one year, you may want to hold off on a §1031 exchange and just pay the taxes that year at a lower rate than you would later if you know you’re going to be making more money in the future.

Additionally, if you have a loss on the year, there would be no gainon which to pay taxes, so it wouldn’t make sense to do a §1031 exchange in that instance either. Capital losses are limited to $3,000 per year for single individuals. Or, if you are in a low enough income tax bracket that you fall into the 0% capital gains tax bracket, you also wouldn’t pay anything and exchange would serve no purpose.

Lastly, if you want to invest in something that is not real estate, you may want to pay the taxes in order to have the cash in hand to invest in something else.

Using 1031 Exchanges for Estate Planning & Tax Deferral

The 1031 Exchange is a real estate strategy used by sophisticated investors for deferring capital gains and also for estate planning purposes. Heirs of real property are positioned receive a full step-up in basis, which is an extremely powerful and advantageous tool for real estate investors – especially if they have performed multiple exchanges and traded up into larger, quality assets.

How It Works

Keep Exchanging & Plan for a Full Step-Up in Basis for Your Heirs

When considering a 1031 Exchange, an investor is looking to “defer” their capital gains on their sale of investment property. More often than not, experienced real estate investors have built equity on their property through proper management & appreciation.

However, when it comes time for the sale of their property, many investors are unaware of the rate of their gain is actually being taxed! While we always advise that our clients consult with their CPA, our experience in the field allows us to estimate what this amount would ultimately be. This particularly applies to owners of rental property that they have fully depreciated and held on for many decades.

The 1031 Exchange is the perfect vehicle to defer the gain in its entirety while simultaneously planning for their estate. Once the properties are inherited, heirs receive a full step-up in basis based on the fair market value of the property at the time the property is passed on. As a result, the heirs are able to depreciate the property as if they had purchased the property that same day. This creates an increased depreciation deduction based on the straight-line depreciation of future market value.

Real World Example

One of our clients purchased a multi-family property in the early 1990s for $500,000. The client had been depreciating the property each year based on the initial acquisition price. Assuming the land value was $100,000 and the building value was $500,000: the client is able to deduct approximately $10,250 per year on their Schedule E ($400,000 / 39 Years).

As the years progressed, the client had exchanged “up” into larger, higher-quality properties. While utilizing the 1031 Exchange as a tool to defer their gains at each selling point so that they would not be taxed on their net profits, the client was also able to build their portfolio to approx. $5,000,000 in rental property based on current market value. Sadly, the client passed away last year.

While the client had been taking advantage of depreciation, their original tax basis had been reduced to just a few more years until there was none left to be depreciated. The moment he passed, following the instructions provided by his Living Trust, his heirs were able to inherit his portfolio & receive a full step-up in basis.

Meaning: Using straight-line depreciation on commercial property (39 years), the heirs were able to depreciate their properties based on the full $5,000,000 valuation. Assuming land value was $500,000, this means that the client was able to deduct $115,380 per year ($4,500,000 / 39) – a significant increase from what was being deducted when this portfolio began in the ’90s!

While each investor experiences a variety of different situations for their portfolio, we hope this illustration provides crucial knowledge on how to maximize 1031 Exchanges.

Popular Markets for 1031 Exchanges

Because 1031 exchanges can be performed in all 50 states through this tax mechanism, you are able to swap your in-state properties for out-of-state properties. Based on trends, here is a top 10 ist of popular real estate markets where 1031 exchanges are being explored the most as of 12/20/2020:

  1. California (San Diego, San Fransico, Los Angelos)
  2. Texas (Houston, Austin)
  3. Colorado (Denver)
  4. Florida (Orlando)
  5. Hawaii (Honolulu)
  6. Indiana (Indianapolis)
  7. Utah
  8. Oregon (Portland)
  9. Arizona
  10. Kentucky

Have Questions? Get Help from the Pros

Is your head spinning with the possibilities of 1031 exchanges? Not to worry, our team of experts here at TFS Properties is here to help. Our seasoned personnel can assist you with the entire exchange so it’s a smooth and painless process for you as a real estate investor. Pick from our inventory of turnkey off-market rental property, strategically placed in stable US markets. Call us today or submit an introductory form to get started.