Nels Larsen, CPA, CMA, CFM
What All Real Estate Investors Need to Know About 1031 Exchanges
Updated: Jan 14
1031 Like-Kind Exchanges for Real Estate Investors
If you're a real estate investor, you've probably heard of 1031 like-kind exchanges. These transactions allow investors to defer capital gains taxes when selling one property and reinvesting in another. While the concept may seem complicated, this blog post will break down the basics of 1031 exchanges so that you can make informed decisions about your investments.
What is a 1031 Exchange?
A 1031 exchange (also known as a like-kind exchange) is an IRS-approved tax strategy that allows investors to defer capital gains taxes when they sell an investment property and reinvest in the purchase of another property of 'like-kind'. It can potentially be repeated for future properties, using 1031 exchanges thereby deferring these taxes for years, decades, or even until the original taxpayer dies and passes the property to their heirs (when a stepped-up basis may reduce or eliminate the tax burden).
What Kind of Property Qualifies?
In general, almost any type of real estate qualifies for a 1031 exchange including residential homes, commercial buildings, raw land, and even vacation rentals. However, certain types of properties such as artwork and collectibles do not qualify under IRS guidelines so be sure to check with your accountant before engaging in an exchange involving those kinds of assets. Additionally, personal residences do not qualify for like-kind exchanges unless they have been used as rental properties for at least two years prior to their sale; otherwise they will be treated as primary residences which means any capital gains incurred from their sale would not be eligible for deferral through an exchange.
How Does the Exchange Work?
To qualify for a 1031 exchange, all of the proceeds from the sale must be reinvested into similar property (called replacement property) within 180 days of the sale of the original property (called the relinquished property). Within this 180 day period, the first 45 days require the seller to identify qualified replacement property that they are going to attempt to purchase. There are also other requirements such as needing to have owned the relinquished property for at least two years.
What is the Potential Tax Benefit?
It is important to understand how a 1031 exchange will affect your taxes. Generally speaking, when you employ a 1031 exchange, you defer any capital gains taxes until you eventually cash out or sell the new property for income. You also do not need to pay any taxes on any appreciation or depreciation until you sell or cash out of the new property. This strategy of kicking the tax can down the road can be repeated over and over with the same original investment being used to acquire subsequent new properties, over a period of years, even decades. If, when you die, you own a property that was acquired using a 1031 exchange, your heirs get a step up in the tax basis to the fair market value of the property. What this means is potentially your heirs could inherit the investment property and not have any income tax ramifications. This strategy is referred to as “Swap 'til you drop”. As always, it's best to consult with your accountant or financial advisor before engaging in any kind of investment strategy.
Using a Qualified Intermediary
When engaging in a 1031 exchange, it’s important to use a qualified intermediary (QI). A QI is an independent party who holds onto funds while they are being transferred between seller and buyer. This helps ensure that the rules of the exchange are followed - namely, that all money received from the sale is reinvested in similar property within 180 days. If any funds from the sale of the relinquished property go to the seller, the 1031 deal blows up and cannot be fixed. The QI will also handle all paperwork associated with the transaction to ensure everything is done according to IRS guidelines.
1031 like-kind exchanges can provide real estate investors with significant tax savings opportunities by allowing them to defer capital gains taxes when selling one property and reinvesting in another. However, there are strict rules involved with these exchanges includ
ing length of holding period requirements and what kind of properties qualify so be sure to consult with your accountant or tax advisor before engaging in any kind of investment strategy involving them. With proper planning and guidance from an expert, real estate investors can take advantage of this powerful tax strategy.