Typically, when an investor sells commercial real estate, they are subject to either short-term or long-term capital gains tax, depending on how long they’ve owned the property. For someone in the highest tax bracket, this could translate into handing over 20% of the proceeds from their sale. For anyone who has invested in their property or otherwise experienced appreciation, this can be quite the financial hit.
Savvy real estate investors will avoid paying this capital gains tax by using what’s known as a 1031 exchange. Section 1031 of the Internal Revenue Code (IRC) allows people to defer paying those capital gains taxes if they reinvest the proceeds in a “like-kind” asset. Many investors do this in perpetuity—and in doing so, put more money back in their pockets while growing their real estate portfolios.
This guide discusses the basics of 1031 exchanges and provides key tips to follow for a successful experience. Read on to learn how utilizing 1031 exchanges can help you hyper accelerate your wealth by investing in real estate.
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What is a 1031 Exchange?
In short, a 1031 exchange is a tax provision that allows someone to sell a property, defer paying capital gains taxes, and then invest the proceeds from that sale into a new property. The general strategy is to defer paying these taxes, which increases a person’s cash position to invest in a new property. Typically, investors use 1031 exchanges to buy higher value properties that have greater cash flows (or potential cash flows) than the properties they’re selling.
Understand What Qualifies as a 1031 Exchange.
Before attempting to use a 1031 exchange, you must understand what qualifies as an exchange. To qualify, the new property must be of “like-kind” as the property being exchanged. Most investment property is considered like-kind for the purposes of a 1031 exchange. You cannot, for example, sell an apartment building and roll the proceeds into the sale of a boat or exchange for shares in a business.
The quality or grade of the property being traded does not matter. For example, you could trade a residential property for an office building. You could trade vacant land for a storage facility, or for another piece of land that you intend to develop. It could be the sale of a Class C property for a Class A property and vice versa. The type and quality of real estate does not inherently matter.
Properties used for personal use, like a primary residence or vacation home, do not qualify for 1031 exchanges.
1031 exchanges can include like-kind property exclusively (e.g., selling a four-unit apartment building and trading up into a 20-unit building). It can also include the sale of like-kind property in addition to cash, liabilities, and property that are not like-kind. For example, a business owner might sell their company alongside the building and its property. Any property that is not considered like-kind may trigger some taxable gain in the year of the exchange. Therefore, some transactions can result in both deferred and recognized gains at the same time. While this complicates some 1031 exchanges, it also opens the door for a wider range of transactions.
Who Qualifies for a 1031 Exchange?
Owners of investment and business property are generally eligible to utilize 1031 exchanges. Individuals, C-corps, S-corps, general and/or limited partnerships, LLCs, trusts, and any other tax paying entities can utilize 1031 exchanges to defer paying capital gains taxes after the sale of real property.
Learn the Timing Requirements associated with 1031 Exchanges.
To qualify for a 1031 exchange, you must carefully follow the rules laid out by the IRS. The biggest rule has to do with timelines. There are two timelines that govern 1031 exchanges.
The 45 Day Rule
The first is that you must identify the replacement property (or properties) in writing within 45 days of the sale of your property that you intend to exchange. This notice must go to the seller and/or what’s known as a “Qualified Intermediary” (QI). An 8824 Form must also be filed with the IRS to report the exchange. Simply giving notice to your attorney or real estate agent is insufficient.
In the case of real estate, this notice must include a legal description of the property to be acquired, street address, and/or any other distinguishable name of the property.
The 180 Day Rule
The property must then be acquired within 180 days of the sale.
Additionally, both transactions must be completed no later than the due date of the tax return for the year of the exchange. In some cases, you may be able to file a tax return extension to better align with the 180 exchange period.
It is important to keep track of these dates in order to stay compliant with IRS regulations and avoid any potential penalties.
Know the Different Types of 1031 Exchanges
Many people do not realize that there are different types of 1031 exchanges.
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Deferred Exchange:
These are the most common types of 1031 exchanges. With a deferred exchange, the owner sells their property, identifies new property, and rolls the proceeds into the sale of that period within the standard 180-day window.
Any proceeds from the sale of the relinquished property that will be used to acquire the new property must be held by the Qualified Intermediary in the interim. Taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind treatment and make a gain immediately taxable.
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Reverse Exchange:
There are some situations in which a person wants or needs to purchase a property before they can sell their existing property. This is when they might consider using a reverse exchange. This is possible so long as the person does not hold title to both properties at the same time. Instead, they must use a Qualified Intermediary to hold title to the new property until the old one sells.
The timeline for reverse exchanges is similar. In this case, you have 45 days to ID the property you want to sell and 180 days (from the date of purchase) to sell and take title to the property the QI is holding for you.
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Simultaneous Exchange:
The simultaneous exchange is the easiest of the exchanges to complete. This is when the sale of relinquished property occurs on the same day as the purchase of the new property. The sales are staggered in a way to receive the proceeds that can be rolled directly from one transaction to the other. In practice, simultaneous exchanges are rare; people generally need more time to facilitate the follow-on transaction, hence the 180-day window.
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Improvement Exchange:
An improvement exchange allows an investor to purchase a replacement property and then, within 12 months, make improvements to that property prior to selling their relinquished property. These exchanges are ideal for value-add investors who need to move quickly on a transaction and/or for buyers looking to construct a new building and/or substantially improve an existing asset. Improvement exchanges are sometimes referred to as “construction exchanges”.
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Other 1031 Exchange Rules to Follow
In addition to the very important 45- and 180-day timelines, there are a few other rules to follow when doing a 1031 exchange.
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The Three Property Rule:
According to the IRS, up to three properties may be identified for acquisition (or sale, if doing a reverse exchange) during the 45-day window. As long as you close on one of those properties, the exchange will qualify.
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The 200% Rule:
In some cases, an owner may identify more than three properties during that 45-day window. In these situations, the 200% rule would then govern. The 200% rule stipulates that investors may identify an unlimited number of replacement properties so long as the value of those properties isn’t 200% more than the value of the property being relinquished.
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The 95% Exception Rule:
There is a caveat to the 200% rule, which is known as the 95% rule: investors can acquire more than three properties where the total value is more than 200% of the relinquished property as long as that individual acquires at least 95% of the value of the properties identified.
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Prepare the Documents Needed for Your 1031 Exchange.
To ensure a successful 1031 exchange, you’ll need to prepare the necessary documents from both the sale of your initial property as well as the purchase of the replacement property. It is important to retain records of all deeds, escrow instructions, closing statements, and other applicable paperwork. You may also need to provide evidence that funds were held in a qualified intermediary account. Make sure you have all your documents in order before embarking on the 1031 exchange process.
Make Sure You Have an Experienced Facilitator on Your Side.
An experienced 1031 Exchange professional can help you organize your documents, ensure compliance with all relevant IRS regulations, and guide you through the entire process of setting up a 1031 Exchange. Finding an experienced facilitator is an essential step towards successful investing. Experienced professionals know the ins and outs of the industry and can provide invaluable advice on how to best set up your exchange for maximum returns.
Understand That Tax Payments are Deferred—Not (Always) Forgiven
Utilizing a 1031 exchange is a great way to defer paying capital gains tax that you would otherwise realize when selling investment property. Eventually, the IRS will expect you to pay those capital gains. This generally occurs when you inevitably sell the property. In the meantime, this deferral increases your liquidity and allows you to continue growing your real estate portfolio.
Some people will wait until retirement to sell their real estate. The assumption is that you will be in a lower tax bracket in retirement, and therefore, the amount you pay in capital gains taxes will be lower than it would be during your prime earning years. Therefore, you might be subject to only 5% or 10% in capital gains instead of 20%. That’s one way to “save” money.
Yet some investors opt never to sell at all. Instead, they put the real estate into a trust that eventually goes to their heirs. Their heirs get the property at what’s called a “stepped-up basis”. When the taxpayer dies, the built-in gains disappear and the full value “resets” with the new owners. This is why you will often refer to investors as using 1031 exchanges to build generational wealth. Some people use the 1031 exchange provision in perpetuity to avoid paying taxes as the property continues to be passed on, generation after generation.
Is a 1031 Exchange Right for You?
Investors will want to do a comprehensive review of their real estate portfolios each year. Doing so provides a better understanding of which properties are cash flowing best, which have appreciated, their equity position in these properties, and whether the property is ripe for sale – based on all of these factors, but also market conditions.
For example, if a value-add investor has executed its business plan for a particular asset and the property is now stabilized, its future appreciation potential may be limited. This type of property could be a great candidate for a 1031 exchange. By selling to someone else, perhaps a passive investor looking for a stabilized property, that value-add investor can “trade up” to a new deal where they can increase their equity and/or cash flow positions.
Carefully Consider How to Maximize the Benefits of a 1031 Exchange
Maximizing the benefits of a 1031 Exchange requires careful consideration. Before initiating any exchange, it is important to understand how long-term capital gains taxes may affect your returns and what type of property you should be exchanging for. Making sure to take the proper steps to ensure compliance with IRS regulations is also essential for successful investing. Working with an experienced 1031 Exchange professional can help ensure that your exchange is set up correctly and will provide maximum return on investment.
