When you invest in real estate, you may be hoping to sell the property for a profit someday. There’s only one problem, though: capital gains taxes—aka Uncle Sam’s share of your earnings.
As market values go up, it may feel like the perfect time to sell your rental property or office building. But the taxes can be difficult to afford. Luckily, there is a way to postpone what you owe. The 1031 exchange, or a like-kind exchange, may allow you to delay your tax bill.
“It’s a powerful tax-deferring strategy,” said Bret Scholl, CPA, CGMA at Scholl & Company in Monterey, California. These transactions may seem like the answer to your tax woes—but only if you follow the rules. Here’s a look at everything you need to know about 1031 exchanges.
What is a 1031 exchange?
When your property has increased in value, it may be possible to sell without paying taxes right away. You can complete this tax-friendly transaction through a 1031 exchange. To qualify, it must be a business property, said Marianela Collado, CPA/PFS, CFP®, CEO and senior financial adviser of Tobias Financial Advisors in Plantation, Florida.
The 1031 exchange involves selling real estate and using the money to buy another like-kind—or similar—type of property. You may delay a tax bill until you sell the second property if you meet these requirements:
- You must hire a qualified intermediary—or a facilitator—to handle the sale and repurchase of the new property.
- You must use the property in a trade or business. Some examples may include a commercial building or rental property. Your primary or secondary home won’t count.
- After selling the property, the money goes to the qualified intermediary. You must identify a replacement property within 45 days.
- You must close on the replacement property within 180 days.
- If you use all the money to buy a replacement property, you can defer the profit from the original property. The basis—or your original property’s purchase price—moves over to the new property.
Another name for the 1031 exchange is the Starker exchange—named after a series of court cases from the 1970s. The Starker family exchanged timber land for a replacement within a specific period of time. The court allowed them to delay taxes on the sale, creating the first 1031 exchange. Now, the 1031 exchange is part of the IRS code section 1031.
A couple of decades later, the IRS added another section to curb abuse between family members. If you complete a 1031 exchange with a family member, you can’t sell the property for two years. Otherwise, both parties have to recognize the delayed tax gain or loss. There are a couple of exceptions, of course. The related-party tax penalty won’t apply if one party dies or if the city involuntarily converts your property.
Who can benefit from a 1031 exchange?
There are several types of property owners who may benefit from a 1031 exchange. Scholl said it can be a good move if your property value has increased and you want to delay paying taxes on a sale. Likewise, if your property value has declined, you may try a 1031 exchange to buy something else.
Let’s say you’re a 70-year-old living in Florida with a rental property in New York. If you bought the property many years ago for $100,000, that is your cost basis. As you hoped, the property value has increased and now it’s worth $1 million.
If you sell the property now, there will be a taxable gain of $900,000. At a tax rate of 23.8%, you would have to owe $214,200 in taxes. That doesn’t include New York taxes, which may be another $70,000—yikes!
Still, you may be eager to get rid of the New York property because it’s tough to manage from far away. Rather than selling it and paying $284,200 in taxes, you could do a 1031 exchange for a property in Florida. With the right rental property, you may earn a similar amount of money.
If you keep the property until death and pass it along to your children, the law allows them to enjoy a step-up in basis. This means their new basis will be the fair market value of the property at your death—which should be close to $1 million versus $100,000. And if they decide to sell the property, they will have a much smaller taxable gain.
Types of 1031 exchanges
There are four different types of 1031 exchanges to be aware of. Here’s a brief rundown on the key differences between each one.
- Simultaneous exchange: Two owners exchange their properties at the same time. The exchange happens in one transaction. Scholl said simultaneous exchanges aren’t as common as the other types of exchanges.
- Delayed exchange: An owner sells their original property before buying the replacement property. Delayed exchanges are the most common type of exchange.
- Reverse exchange: An owner buys a replacement property through an exchange accommodator before selling their current property. These are sometimes called forward exchanges.
- Construction or improvement exchange: These exchanges allow a property owner to construct or make improvements on replacement property with exchange equity. “This allows you to use the difference between the sale and purchase price to improve or renovate the new property,” said Collado.
1031 exchange rules
Before embarking on a 1031 exchange, you’ll want to understand what you’re getting into. There are several moving parts—and plenty of costly mistakes to make. “Don’t look at a transaction in the vacuum. You have to look at all the pieces of the puzzle,” Collado suggested. These are the six basic 1031 exchange rules to know.
Rule 1: Like-kind property: To qualify for a 1031 exchange, the property must be like-kind. These properties must be “of the same nature or character, even if they differ in grade or quality,” according to the IRS. For example, you can exchange real estate for another piece of real estate. But you can’t exchange domestic property for foreign property.
Rule 2: Investment or business property only: Personal property does not qualify for a 1031 exchange. You must use investment property or property used in your trade or business.
Rule 3: Related persons: If a 1031 exchange happens between relatives, both parties must wait two years before selling their new property.
Rule 4: Must not receive ‘boot’: If you receive anything more than like-kind property, like cash—also called “boot”—the 1031 exchange won’t be completely tax-free. “When you receive boot, it’s taxable up to the amount of the gain,” said Scholl.
Rule 5: 45-day identification window - You must identify the replacement property within 45 days of the original property’s transfer. This window of time is the identification period. You may identify up to four properties during this 45-day window.
Rule 6: 180-day purchase window: You must receive the replacement property within 180 days. You’ll have to receive the same property that you identified earlier. Sometimes buyers change their minds about a 1031 exchange. If they need quick access to their money, it could be a problem. Scholl said the exchange accommodator must hold the funds until the 180 days have passed.
How does a 1031 exchange work?
There’s no doubt about it—1031 exchanges can be confusing. To understand the tax consequences, it may help to see a real-life example.
Let’s say Mike and John complete a 1031 exchange for their like-kind properties. Mike paid $25,000 (the basis) for his property in Tennessee, and it’s now worth $40,000. John paid $20,000 (the basis) for his property in North Carolina and the value is now $30,000.
Because these properties don’t have the same fair market value, John agrees to pay something extra to make it even—aka the boot. He agrees to give Mike stocks worth $10,000. He paid $7,000 (the basis) for them. Here’s what this transaction will look like from a tax standpoint:
Mike’s old Tennessee property
Fair market value $40,000
- Basis $25,000
= Deferred taxable gain $15,000
Recognize boot received
as current taxable gain $10,000
Mike’s new North Carolina property
Fair market value $30,000
- Carryover basis from
Tennessee property $25,000
= Deferred taxable gain $5,000
It pays to know the tax code
The 1031 exchange offers the unique opportunity to save on taxes. But it’s critical to understand these transactions have a complex set of rules. Don’t proceed without getting the right type of advice on the exchange. “Make sure your tax adviser is a 1031 exchange expert,” said Scholl.
Ask about their experience with 1031 exchanges. Scholl said there is a big difference between working on one from the beginning and preparing a tax return after the exchange has occurred. You may rest easier at tax time knowing your transaction followed all the rules—from start to finish.