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 deferment 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, not only essentially exchange property in a high-priced market for one (or often several) properties in one or more up-and-coming areas of the country, but do so without incurring current capital gains taxes on gains at the time of the swap, but defer taxes until a later date.
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.
What is a 1031 Exchange?
Section 1031 of the IRS code details how a 1031 exchange works. Essentially, it allows an investor to defer the payment of capital gains taxes incurred by selling an investment property (the Downleg), so long as the profit from the property sale is used to purchase a like-kind property (the Upleg).
This type of exchange provides benefits beyond the obvious financial benefit of tax liability deferment – 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.
Watch this 2-minute video explaining how typical 1031 exchanges work using real examples.
1031 Exchange Requirements
Tthe 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 negotiate.
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 appropriate uses for each one.
Delayed 1031 Exchange
Delayed 1031 exchanges are perhaps the most popular because they provide an extended timeframe in which to complete the exchange. 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 exchange intermediary.
In the industry, this third party is known as a Qualified Intermediary (QI) or an Accommodator. The QI 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 identify one or more potential replacement properties and an additional 135 days to close on those properties, making it a total of 180 days to complete the entire exchange with the identified properties. This takes some pressure off the deal and allows the investor to sell while the market is in his or her favor and then take some time to select the best possible replacement property or properties.
At least that’s the theory. In reality, the extra 45 days to find replacement property helps, but experience has shown that that time period can go by very quickly. Especially in a “hot market” with many bidders for good quality deals, you can waste many days chasing that perfect property only to see it get bid way too high. Be sure and have a very clear “game plan” in place before selling your original property.
Reverse 1031 Exchange
A reverse exchange or forward exchange, which is not very common, 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 property afterward.
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 be forfeited and capital gains taxes will be collected.
Simultaneous 1031 Exchange
A simultaneous 1031 exchange requires that both the relinquished and replacement properties close on the same day at the same time. Even a slight delay caused by the money transfer process or some other hindrance can disqualify the exchange and result in the immediate application of the full amount of capital gains taxes.
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:
- 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,
- the investor must receive a property that is substantially the same as that which they identified by the 45th day of the deal, and
- the replacement property must be of equal or greater value when the investor receives the deed back from the intermediary after 180 days.
1031 Exchange Timeline
At its longest, 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.
1031 Exchange Case Studies
A common goal when investing in real estate should be to exchange highly appreciated investment properties and take that equity to be deployed into strong cash flowing turnkey rental properties in stable markets around the United States. A 1031 exchange is a great vehicle to achieve this goal.
- NNN Lease
- Single-Family Rentals
- Multi-Family Apt
- Manufactured Homes
1031 Exchange Rules
There are seven primary rules that must be met for a successful 1031 exchange. Let’s look at what each rule entails:
#1 Like-Kind Property
The relinquished and acquired properties must be like-kind, 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 buildings, industrial buildings, vacation rentals, raw land or retail properties can all be exchanged with each other, since they are all essentially considered to be the comparable assets.
Basically any property other than your primary residence that has a deed and was purchased as an investment. This also means that you can exchange one large property for several smaller ones and vice versa. As long as the total value of the purchased property is equal to or greater than the sales price of the original property (the Downleg).
#2 Investment or Business Properties Only
1031 exchanges can only involve investment or business real estate properties, not personal properties. That means that you cannot exchange your primary residence for another primary residence, or a primary residence for an investment or business property.
#3 Equal or Greater Value Property Only...
To have 100% of the capital gains 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 the fair market value of your property is $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. Acquisition costs such as inspector and broker fees can also be factored into the total cost of the new property or properties.
...Or #4 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 capital gains 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 capital gains taxes on the $500,000 difference.
The capital gains tax rate depends on your income tax bracket and can be 0%, 15%, or 20%. The tax bracket requirements typically change every year, 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%. In addition, you will have a state income tax, depending on what state you reside in. Unfortunately, if you’re a Californian that additional tax can be as high as 13.5%.
#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 to sell the relinquished property and your individual name to purchase the replacement property.
#6 45-Day Identification Window
Once you close the sale of your relinquished property, you have 45 days to identify possible replacements for one of three potential like-kind property types for replacement.
#7 180-Day Purchase Window
Once you’ve sold your relinquished property, you have 180 days to close on the purchase of the replacement properties. 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 replacement properties.
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 (generally referred to as an “Accommodator”) 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.
Calculate Your 1031 Exchange Due Dates
Use our 1031 Exchange calculator to find out your 45-day and 180-day windows are.
When To Do a 1031 Exchange?
The best time to do a 1031 exchange is any time you are facing significant capital gains tax when selling an eligible property. The value of 1031 exchanges is amplified if you are in a high tax bracket that would require you to pay a high percentage of capital gains taxes.
A primary benefit of 1031 exchanges is that it allows you to keep more cash from your sale, giving you more to reinvest and expand your real estate portfolio faster. By deferring the capital gains taxes on the sale of your properties, you aren’t giving a larger than required portion of your investment capital to the government.
There is no limit on the number of 1031 exchanges you can do (even with the same investment capital), so you can keep investing and swapping properties for as long as you like, and then only pay the capital gains taxes once when you sell your properties for cash. As a legacy tool, your deferred capital gains taxes may be eliminated entirely after your death.
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.
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 down the line.
Additionally, if you have a capital loss on the year or a carry forward loss from earlier years you can offset your capital gains with the loss. In that case, it wouldn’t make sense to do a 1031 exchange. Or, if you are in a low enough income tax bracket that you fall into the 0% capital gains bracket, you also wouldn’t pay capital gains taxes, so an 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
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.
What is a 1031 Exchange?
A 1031 Exchange stems from IRS Code Section 1031 and allows for an investor to defer his capital gains tax during the sale of an investment property through an exchange of sale proceeds of an existing property being used in the purchase of a new property.
How Does A 1031 Exchange Work?
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.
What Are The Rules Of A 1031 Exchange?
There are many rules to a 1031 Exchange, but the most critical ones are the deadline rules.
- After the sale of your property, you have 45 days to identify one or more property you would like to exchange into.
- Within 180 days of your sale, you must complete the exchange or incur capital gains tax
Speak to a 1031 Exchange Specialist Today!
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 to get started!