1031 Exchange Rules & Benefits
A 1031 exchange is one of the most powerful tools available to real estate investors. The 1031 exchange allows a real estate investor to avoid paying taxes on the sale of his or her property by rolling the proceeds into a new one. However, 1031 exchange rules can be tedious, and missing a step can cost you a lot in lost tax benefits.
Let’s go over the basics of 1031 exchanges and the rules to watch out for:
What Is a 1031 Exchange?
A 1031 exchange is a creature of the tax code.
Section 1031 of the Internal Revenue Code allows an investor to postpone paying capital gains taxes on a sale if the investor uses the sales proceeds in a “like-kind exchange.”
Normally, when someone sells a rental property, that person has to pay taxes on any capital gains that they might have earned from the sale.
For example, if a person initially bought a property for $200,000 and later sells it for $250,000, the difference between the purchase price and sales price is the capital gain, which is $50,000 in this case ($250,000 – $200,000). If the person wanted to pocket that cash, he or she would have to pay taxes on the $50,000, generally.
But, with a 1031 exchange, an investor doesn’t have to pay taxes on the $50,000. Instead of pocketing the cash, the investor must move all of the proceeds of the sale into a new property. The IRS will look at this “like-kind exchange” from one piece of real estate to another and won’t bill the investor for capital gains taxes.
This means that a real estate investor can sell one piece of real estate to purchase another and avoid paying taxes on the gain!
It’s important to clarify that the gains in a 1031 exchange are tax-deferred, not tax-free. If an investor buys a property, sells it via a 1031 exchange to buy a second property, and then sells that second property, the investor will have to pay capital gains taxes on the gain for the first and second sales. Unless, of course, the investor does yet another 1031 exchange towards a third property.
There are a number of 1031 exchange rules. Investors have to tread carefully to avoid squandering the benefit of the exchange. Let’s go through those now.
1031 Exchange Rules & Steps
While powerful, 1031 exchanges have a number of strict (and sometimes tedious) rules to follow. If each step is not followed carefully, the whole transaction could end up triggering an unexpected tax bill!
1031 Exchange Timeline
- Investor sells Property #1.
- The investor identifies potential replacement properties within 45 days of closing the sale of Property #1.
- The investor must close on the replacement property within 180 days of closing on the first property’s sale.
- Capital gains taxes are deferred on that exchange!
While the general process is quite simple, there are a number of special rules that an investor needs to pay attention to.
Types of Property
1031 exchanges are only available for investment properties. This means that a person can’t use a 1031 exchange on his or her primary residence (though there are many other tax advantages for that!). These exchanges are designed to encourage investing in more rental or commercial property.
However, an investor could sell, say, a commercial office building via a 1031 exchange and buy a different type of rental property, like a multifamily apartment. Similarly, a person could sell a house that they are renting and use the proceeds towards buying a shopping center.
Identified Property Limitations
Unfortunately, an investor cannot just identify every single property on the market to meet the identification requirement, at least not without significant drawbacks.
Generally, the more properties a person identifies for a 1031 exchange, the more restrictions there are.
An investor only has a few options:
- Identify up to three properties with the intent to purchase at least one. The properties can be of any value.
- Identify four or more properties, so long as their cumulative value does not exceed 200% of the sold property’s value (ex: the initial property sold for $1,000,000, so an investor can identify four properties each worth an average of $500,000).
- Identify four or more properties with a cumulative value exceeding 200% of the sold property’s value, but the investor has to close on each of the properties for at least 95% of the identified values.
As you can see, an investor can’t use a “shotgun” approach without consequence if he or she wants to follow 1031 exchange rules. An investor has to be careful with identifying properties within the 45-day window.
Benefits and Drawbacks of 1031 Exchanges
1031 exchanges, while powerful, might not be the best option for every person. Let’s go over their benefits and drawbacks.
The most obvious benefit is the potentially massive tax savings. If the sold property has large amounts of capital gains, the tax bill on those gains might be, similarly, very large.
This allows an investor to keep more of their money in building up a larger rental property portfolio.
1031 exchanges can be useful for consolidating a portfolio as well. If an investor has many, smaller properties and wants to replace them with one, bigger property, this tool can let them do that tax efficiently.
From a policy perspective, 1031 exchanges encourage investors to keep their capital invested in real estate. This can help to improve overall real estate quality by keeping more investors in the real estate “game” as opposed to moving their money elsewhere.
The clearest drawback of a 1031 exchange is that an investor has to pay special attention to the deadlines listed above. Market conditions can change on a moment’s notice, and that can make a 1031 exchange very stressful.
Similarly, real estate transactions can take a while. It can be hard to search for a property worth more than the previous property that also meets an investor’s criteria, get it under contract, and close on it all within 180 days.
Because taxes are deferred, an investor has to be careful if he or she ever wants to liquidate a real estate position. Especially if they have had a large amount of deferred capital gains taxes from one or more previous exchanges, an ultimate sale could trigger a huge tax bill.
There are some tax planning strategies that can help to avoid that final tax bill, but that is beyond the scope of this article. It is worth speaking to a licensed tax professional about that issue if you need assistance.
1031 exchange rules are a bit complicated, but their benefits can be very lucrative. Deferring taxes on capital gains can save an investor a lot of money, money that can be used to purchase more real estate.
An investor has to be careful to follow all of the rules outlined above and understand the limitations that come with 1031 exchanges!
However, like any law, 1031 exchange rules are always subject to change. It is worth speaking with an attorney to discuss your options to figure out the most efficient strategy for your goals.
Contact an Experienced 1031 Exchange Attorney
1031 exchanges can be complicated to execute, but their benefits can be tremendous. Contact the experienced attorneys at Johnston Tomei Lenczycki & Goldberg LLC. We can help to design a strategy that works best for you. Call us today at (847) 549-0600 or email us at firstname.lastname@example.org to schedule a free consultation.