1031 exchanges can be a real estate investor’s best friend, and hopefully not his worst nightmare. In this ultimate guide to 1031 exchanges you will get all of the information you need to ensure you get the maximum benefits from doing a 1031 exchange. By knowing the specific rules laid out by the IRS and the exact time frames you need to follow, you can avoid a tax disaster and subsequently increase your wealth dramatically.
What are 1031 exchanges?
A 1031 exchange is a way to defer tax payments on a real estate investment. It is an exchange because you avoid capital gains taxes that you would otherwise pay by exchanging one property for another property.
In short, you can sell your property and buy a new one without paying any taxes on the sale. There are very specific rules which must be followed in order to qualify for a 1031 exchange. The 1031 number refers to internal revenue service section 1031 which lays out all the rules on 1031 exchanges.
The Benefits Of Doing a 1031 Exchange
The primary benefit of doing a 1031 exchange is that you avoid paying taxes on the sale of your property. For example, let’s say five years ago you bought a property for $2,000,000 that is now worth $2,500,000. If you sell it you will pay between 15% and 25% capital gains tax on the $500,000 profit (depending on which state you are in, your income etc.) But by doing a 1031 exchange you will pay zero taxes on the $500,000.
A 1031 exchange essentially allows you to invest all of your profits into a new real estate investment without having to pay taxes. To show why this is so advantageous with an example, let’s say that you made a $500,000 down payment to purchase a $2,000,000 apartment complex. After five years the property has increased in value by 25% and is now worth $2,500,000. You decide to sell without doing a 1031 exchange.
After paying a 20% capital gains tax of $100,000 on your $500,000 profit you are left with a $400,000 profit, plus your initial $500,000 investment. Now you decide to take this $900,000 and purchase a new property worth $3,600,000. After another five years the property has increased in value another 25% and is now worth $4,500,000, so you decide to sell again.
You pay another 20% capital gains tax of $180,000 on the $900,000 profit which brings your profit on that deal down to $720,000. So after ten years you have paid $280,000 in taxes and made a total profit of $1,120,000. That’s pretty good, but what if you had done 1031 exchanges?
Using the same numbers, let’s say you made a $500,000 down payment to purchase a $2,000,000 apartment complex. After five years the property is now worth $2,500,000 and you sell it. But this time you do a 1031 exchange, which means you pay no taxes.
Now you have your initial $500,000 plus your whole $500,000 profit for a total of $1,000,000. You use this to buy a $4,000,000 apartment complex. After another five years the property has appreciated by 25% and you sell it for $5,000,000 and do another 1031 exchange. In total you have made a profit of $1,500,000 which is $380,000 more than the $1,120,000 you would have made if you had paid taxes. That’s a 34% increase in profit!
And look at what happens if you keep the scenario going. In the example where you paid taxes you now have $1,120,000 to invest in a new property, which if we continue to assume a 25% down payment, will get you a property worth $4,480,000. But by doing the 1031 exchanges you have $1,500,000 to invest and can purchase a property worth $6,000,000! That means by doing just two 1031 exchanges over the course of ten years you would own about $1,520,000 more worth of real estate than if you had paid taxes.
If you carry this over the entire lifespan of your real estate career, over multiple different properties and investments, you can see how powerful 1031 exchanges are. So while there are a lot of rules that govern them, and a lot of paperwork to be filed, the benefits in terms of your financial gains are massive.
Reasons For Doing 1031 Exchanges (Beyond Taxes)
Obviously the tax advantages of 1031 exchanges are the main reason for using them, but why else do investors use 1031 exchanges? I mean, if an investor doesn’t want to pay taxes, why doesn’t he just hold onto the property? Here’s a few reasons:
- You want to switch from one type of investment to another. For example, you own a vacation rental and want to switch to apartments.
- You want to switch from a property you are actively managing to something more passive. Sometimes investors would rather sell the property they are spending time managing and buy into something that is already under good management.
- You want to consolidate a number of properties into one property, or sell one property and buy a number of smaller ones.
- You want to reset the clock on depreciation recapture (see section below “How Depreciation Recapture Affects 1031 Exchanges”)
So essentially, there are other reasons to sell a property beyond cashing in on the property, and a 1031 exchange makes it possible to move your investment money around without incurring heavy taxes.
How To Qualify for a 1031 Exchange
There are very specific rules that you need to follow in order to qualify for a 1031 exchange. You need to know these rules exactly in order to properly plan and prepare for doing a 1031 exchange correctly. Here are the key rules to know:
The new property must be “Like-Kind”.
IRS Definition of like-kind: “Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality. Real properties generally are of like-kind, regardless of whether they’re improved or unimproved.”
So you can generally exchange any type of investment property for any other type of investment property. You could sell an apartment complex and buy a vacation home or sell an office building and buy a vacant piece of land.
But you couldn’t do a 1031 exchange with the house you live in since it’s not considered an investment property. Also, you couldn’t sell a rental property and buy precious metals like gold, since this would not be a like-kind transaction. Additionally, both properties involved in the exchange must be located within the U.S.
The new property must be identified within 45 days.
As soon as you sell your property the clock starts ticking on a 45 day countdown. You must identify the property or properties you plan to exchange for within this time period to qualify for the 1031 exchange. The properties you identify can be of any value.
You actually have longer than 45 days in reality since you should already be looking for your new property as soon as you list your current property for sale. It’s also important to note that the properties you identify do not have to be on the market. You simply need to formally identify the property or properties in writing and their market value at this stage.
You must close on the new property within 180 days.
As soon as you sell your property you have 180 days to close on the new property with the title transferred over to you. Failure to do so will cancel the 1031 exchange. This is why it’s important to identify back up properties. Even if there is one property you are looking at and everything looks great with the deal, you wouldn’t want the deal to fall through at the last minute and be left without a plan B.
You cannot touch the money from the sale.
Money from the sale of your property cannot touch your bank account in order to qualify for a 1031 exchange. What you need to do is use a qualified intermediary. A qualified intermediary holds onto the money in the interim period between selling your property and buying the new one. There are many trusted companies who can perform this function.
The IRS states that the intermediary cannot be the investor, their broker, their spouse, their family member, their investment banker, their employee, their agent, their business associate, or anyone who has served one of these functions in the past two years. So essentially, the money needs to go to a qualified intermediary who can hold onto it until you close on the new property.
The 200 Percent Rule
This rule applies when you want to identify more than three potential replacement properties. Let’s say you had a building worth $1,000,000 that you wanted to sell and then buy five to ten different rental homes. In this case identifying only 3 properties for your 1031 exchange obviously won’t work. So this is where the 200 percent rule comes in.
The 200 percent rule says that you can identify more than three properties, but their value cannot exceed 200% of the sale of your property. So in this example with a building worth $1,000,000 you can identify as many properties as you want, as long as the total value on them doesn’t exceed $2,000,000.
The 95 Percent Rule
The 95 percent rule applies when even the 200 Percent Rule is too restrictive. This rule says that you can identify as many properties as you want, up to whatever value, but you must close on at least 95% of the value of identified properties in order to qualify for the 1031 exchange.
For example let’s say you were going to sell a building worth $1,000,000 and buy five smaller buildings all worth $500,000. That breaks the three property rule and the 200% rule. But you could still do this transaction as a 1031 exchange if you closed on all five properties (since closing on only four would account for only 80% of the total amount identified). This however would be very risky since if even one of the deals fell through, your whole 1031 exchange would be null and void.
Real World Example of a 1031 Exchange
To illustrate exactly how a 1031 exchange plays out in the real world, here’s an example. Let’s say you own an apartment complex worth $2,000,000 that you want to sell and do a 1031 exchange on. Here are the steps you would go through:
- List your apartment complex for sale. Make sure your broker is aware you will be doing a 1031 exchange. |
- Start looking for the replacement property you will exchange with. In this example your apartment complex is worth $2,000,000, so the property you buy will need to be worth at least that much. Otherwise you will pay capital gains tax on the difference. For example if you bought another apartment complex for $1,500,000, then you would still have to pay whatever the capital gains tax would be on the $500,000 difference. This difference is known as the “boot”.
- Locate a qualified intermediary. This is the company who will hold onto the money from the sale in the meantime before purchasing the new property. Be sure to choose a reputable company with a long history of doing these types of transactions.
- Negotiate and accept an offer on your apartment complex. The buyer needs to be aware that you are doing a 1031 exchange. There is not much work for the buyer, but the buyer will need to sign off on some documents regarding the exchange so will need to be aware of it.|
- Close on the sale of your apartment complex. Once this sale is closed, the funds will be directed into the account of the qualified intermediary you have chosen. These funds will be used to purchase the new property.
- Identify up to three properties to purchase within 45 days. At this point you need to officially designate up to three properties as the replacement properties. Only properties designated at this stage will qualify for the 1031 exchange, so ideally you would have some good options lined up already.
At this stage you could also identify more than three properties, but the total value of properties identified cannot exceed $4,000,000. In this example you decide on a new apartment complex in a better area worth $2,200,000 as your first choice. But to be safe you identify two other apartment buildings of similar value.
- Get your first choice property under contract. The seller will need to know the property is being purchased under a 1031 exchange. You can also get all three properties you identified under contract as a safety net (only closing on your first choice ideally). At this stage you get your first choice, the $2,200,000 apartment under contract.
- The qualified intermediary gets the title transferred. This step is primarily handled by the qualified intermediary you have chosen. They would then transfer the $2,000,000 they have been holding in escrow to the seller.
- Close on the new property. After the title is transferred, the deal will close just like any other similar real estate deal. Since your new property is worth an additional $200,000, you would also transfer this amount to the seller. In this example there is no boot, since the new property is worth more than the relinquished property.
At this point assuming all of the steps were followed, and all the necessary paperwork was filed, you will have completed doing a 1031 exchange.
How To Do a Reverse 1031 Exchange
You can also do what’s called a reverse 1031 exchange where you buy the new property before selling your current property. When you do this, a qualified intermediary will actually hold the title to the new property until your current property is sold.
All of the same rules of a normal 1031 exchange apply except that the time restrictions apply in reverse. In this case after you buy the new property, you have 45 days to identify the property you will be selling. You then have 180 days from the point you purchased the new property to close on the sale of your current property. At that point the qualified intermediary would transfer the title of the new property to you, thus completing the 1031 exchange.
How Depreciation Recapture Affects 1031 Exchanges
Depreciation recapture is a procedure used by the IRS to collect taxes on properties that have been depreciated for tax purposes. Depreciation is another tool you can use to reduce your taxes. In short, each year you can claim a depreciation tax deduction which is essentially an assumed amount that the property has reduced in value due to age, wear and tear etc.
But when you sell your property, the IRS will collect for what is called depreciation recapture. For example, let’s say you bought an apartment building worth $500,000 in cash. In each of these five years you claimed a $5,000 depreciation reduction for a total of $25,000 worth of deductions.
So now let’s say you were to sell this property for $550,000. While you only made a $50,000 profit, you will pay taxes on the difference between the sale price and the depreciated value of $475,000 ($500,000 purchase price minus $25,000 depreciation deductions). That means you owe taxes on $75,000 not $50,000.
Depreciation recapture is typically taxed more than capital gains, and can be 20% or 25%. Lets assume a 20% depreciation recapture and a 15% capital gains tax. You would pay a 20% depreciation recapture tax on the $25,000 totaling $5,000. Then you would pay a 15% capital gains tax on the $50,000 totaling $7,500. So total you would pay $12,500 in taxes on your $50,000 profit.
Even if you were to sell your property at a loss, based on depreciation recapture you may still owe taxes! For example, assuming the same numbers as above where you bought a property for $500,000 and depreciated it $5,000 a year for five years, if you were to sell this property at a loss for $480,000, you would still have a $1,000 tax bill because of the 20% depreciation recapture on the $5,000 ($480,000 sale price minus $475,000 depreciated value).
But the good news is that a 1031 exchange negates all of these taxes which is another excellent reason to use one. Depreciation recapture can be especially rough on your taxes when you have owned an asset for a long period of time and claimed a lot of depreciation deductions. This is why investors want to do 1031 exchanges, because it resets the clock on the depreciations and brings depreciation recapture back to zero. So by knowing about this you can better decide if doing a 1031 exchange is correct for your situation.
Changes To 1031 Exchange Law With the Tax Cuts and Jobs Act of 2017
Before the 2017 tax cuts and jobs act was passed, you could do 1031 exchanges with a lot more than just real estate. For example you could trade your office building for a piece of artwork and still not pay any taxes. But today 1031 exchanges are limited to real property with some small exceptions. Overall it’s important to know that when you do a 1031 exchange, it almost always needs to be for another piece of real property.
How To Never Pay Capital Gains Taxes Using 1031 Exchanges
One interesting thing about 1031 exchanges is that you can do as many as you want. You could use 1031 exchanges from day one of your real estate career, all the way up until the day you die. That would mean avoiding capital gains tax for your entire life! But why stop there?
Actually, by passing on your real estate investments to your heirs, you will avoid taxes forever. That’s because once a property is inherited, it’s inherited on a “stepped up basis”. That means that the cost of the property will be considered to be whatever its market value was on the day that you die.
So let’s say you have a portfolio of real estate worth $10,000,000 which you had built up using 1031 exchanges over many years. If your heirs were to sell it for that amount, they would pay zero capital gains tax because the cost has been “stepped-up” to $10,000,000.
The Bottom Line on 1031 Exchanges
1031 Exchanges are an excellent way to avoid taxes and increase your wealth. It is very important to work with professionals who have experience in doing all of the necessary paperwork to properly complete the transaction. But by knowing the general rules and what you need to do, you can easily do a 1031 exchange and be rewarded with all of the benefits.
