What Is a 1031 Exchange and How Does It Work?

Updated Mar 01, 2021

Real estate investments come with a lot of great benefits. Some of those benefits are tax advantages. As a rental property owner, you can deduct many of the expenses associated with your rental property, including maintenance and mortgage interest, insurance, property management fees, and you can even use depreciation to lower your overall tax liability.

While the benefits are outstanding, there can also be tax penalties when you're ready to sell a real estate asset.

As you probably know, when you buy a property and hold onto it for some time, and you've earned profits from it and taken depreciation credits, there will be a reckoning when you decide to sell that home. You'll have to pay capital gains taxes on the profits you earned on the investment. And, you'll also have a depreciation recapture to manage. That's a lot of money cutting into your ROI, and it can be a substantial drain on your motivation to sell.

Luckily, a 1031 option is available to real estate investors like you. Most investors find that it's a valuable tool for protecting their income from capital gains and other taxes.

What is a 1031 Exchange Program?

1031 exchange what is it

The 1031 Exchange is named for the IRS tax code to which it pertains. It's also known as a Starker Exchange, named after an investor who won a case against the US government that allowed them to use the tax deferred exchange. According to this rule, an investor who has made a profit from a real estate investment or taken depreciation tax credits can defer the tax on both if:

  • they purchase another property of equal or greater value
  • it has to be a like-kind property
  • Everything has to be completed during the specified exchange period by a 1031 exchange

A 1031 Exchange is an incredibly useful tool for many real estate investors, especially when trying to leverage their rental properties. If you find yourself wanting to sell but resisting the urge because you don't want to incur those tax burdens, this program might be precisely what you need. It allows you to unlock the equity and profits you have in your current property and move that money into other properties with more growth potential or diverse investment benefits.

Common 1031 Exchange Terminology

Some terms you need to understand are:

  • The property you want to sell is called the" relinquished property."
  • The property you decide to buy is called the "replacement property."

You'll want to understand the process and its rules completely before you venture into this process. We also recommend working with an expert broker or property manager specializing in 1031 Exchanges.

Deadlines and Restrictions Associated with 1031 Exchanges

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Let's say you have a rental property that you want to sell. You don't want to recapture the depreciation you claimed on your taxes, and you don't want to pay capital gains taxes. So, you decide you're going to sell the property through a 1031 exchange and save yourself some money.

First, you'll probably sell your rental home, making it a relinquished property. Once the sale closes on that deal, the escrow company will move the proceeds from that sale into a qualified intermediary's exchange account.

You need a qualified intermediary to complete the 1031 property exchange.

The exchange facilitator holds the profits you earned from selling the old property.

1031 Exchange Time Requirements

Now, you have 45 days from your original property’s sale to identify the replacement property.

You are also required to close on the replacement property within 180 days of closing on the relinquished property sale.

This timeline might seem relatively easy to follow. With 45 days to identify a property and 180 days to close on that property, you probably feel like you have plenty of breathing room. But, time is of the essence, and we recommend you work as quickly as possible to complete this Exchange. The longer you wait, the more time you have for complications to arise.

1031 Exchange Property Requirements

The other restriction is that you're required to buy a property of equal or greater value. So, if you sold a duplex for $1 million, you are required to buy another rental property for at least $1 million. Or, you can buy several properties as long as they equal $1 million or more.

It's also necessary to exchange one rental for another rental. You cannot use the 1031 exchange to sell a rental home and then buy a piece of land that isn't attached to income. You cannot sell your rental home and then use the 1031 exchange to buy yourself a vacation home. You need to make sure you're making an exchange - changing from one rental property to another rental property.

Another area that's easy to make mistakes is with your qualified intermediary. Ensure you understand that professional's role and the importance of letting them hold your escrow exchange fund. If you touch any of the money made when you sold your relinquished property, you will immediately be subject to paying taxes. You cannot spend that money or move it into your accounts without penalties. Such an action would completely void the 1031 exchange.

The Challenges of a 1031 Exchange

Challenges of 1031 exchange

Many investors and real estate professionals are big fans of the 1031 exchange. It's a straightforward and effective investment tool to save serious money.

But, it's not perfect. It also comes at a price. You need to be prepared to deal with the potential downside of a transaction like this.

Con: 45 Day Timeline

First, there's the pressure of deadlines. While it might seem like 45 days is plenty of time to find a replacement property, it might not be as easy as you think. Markets change all the time, and if you're in a market where there's very little inventory or a lot of competition from other buyers, you might have a hard time locating a suitable replacement property. In a seller's market, it's possible that 45 days may not be enough time to find a replacement property. 

Con: Pressure to Find a Property

What does this mean for you? It means that if you're feeling pressured to find the right property, you might buy something that you wouldn't otherwise buy. You might settle for a property that isn't quite right for your investment goals. This happens a lot as the days begin to dwindle, so be careful; people tend to wait and find a replacement property later in the process or to grasp at any home that's in a price range and available.

These sorts of time crunches provide excellent opportunities for wholesalers selling properties using assignments of contract. Wholesalers find good deals and put together purchase agreements, which can save a lot of time when you’re performing a 1031 Exchange.

It's still important to do your homework before you buy. It's also important that you don't wait too long to find a suitable property for the Exchange. We see many investors who find a great replacement property, but they decide to think about it for a while or continue looking around. They end up not putting the new home under contract and, ultimately, risk losing the property because they waited too long to make a move.

Con: Potential Tax Implications

If you have a failed exchange, you have to pay taxes. Make sure you're prepared to move and make sure you're ready to find and buy a replacement property as soon as possible.

There's another potential danger, and it's a more insidious issue that can trap investors into an endless cycle of 1031 exchange transactions. You might have purchased a property and had some gains in this situation, so you sold it and did an exchange. Then, in two years, you do it again. Then, you do it three or four more times. After 10 or 15 years, you have deferred gains on hundreds of thousands of sale proceeds. Maybe even a million dollars or more in profit. When you're finally ready to unwind that final property and access the cash, your tax liability will be pretty huge. You have all of that capital gain over all those exchanges. You're almost permanently locked in.

Almost...

How Your Heirs Can Inherit Your Property Without Paying Your Deferred Taxes

You might be locked into paying deferred depreciation recapture and capital gains tax, but your heirs don't have to be. If you die before putting an end to your run of 1031 Exchanges, your heirs receive your real estate investment on a stepped-up basis, which means that they get the asset at its fair market value at the time of the owner's death.

Imagine if you began your investment career with a $50,000 property and, via a series of 1031 Exchanges, finished off with a property worth $1 million. Instead of paying capital gains on almost $1 million, your heirs won't have to pay capital gains taxes at all. They may have to pay estate taxes and should, as a result, consult with a financial advisor. But it will be far less than all those deferred taxes they would have paid otherwise!

How a Section 121 Exclusion Can Save You Hundreds of Thousands of Dollars

Thanks to Section 121 of the Internal Revenue Code, the taxpayer is entitled to a $250,000 (if single) or $500,000 (if married filing jointly) exclusion on the sale of any property they own and have used as a primary residence (AKA "principal residence") for 24 out of the last 60 months. With an exclusion, it isn't necessary to pay taxes or reinvest. These 24 months also don't have to be spent consecutively. 

Like a 1031 Exchange, it's prudent to consult with a real estate professional before performing a Section 121 Exclusion to make sure it is done correctly. Here are three examples of its use. 

Straight Forward 1031 Exchange and Section 121 Exclusion

There are several ways in which the 1031 Exchange and a Section 121 Exclusion can complement one another. Here's a straightforward example.

  • You buy a property and live in it for two years. Then you move out and convert it into a rental.
  • You keep the property as an investment for 18 months.
  • You sell the rental property and get to use the Section 121 Exclusion and the tax deferrals from the 1031 Exchange. 

121 Exclusion and 1031 Exchange With Allocation

You can also combine a 121 Exclusion with a 1031 Exchange when a portion of your business property is your primary residence. 

You own a multi-unit rental property. It has four units. You live in one and rent out the three others. You can still use the 121 Exclusion and 1031 Exchange just like in the straight forward example, except you would need to "allocate" the part used as a principal residence when performing the 1031 Exchange.

When you perform your 1031 Exchange, you'll allocate the principal residence part and employ the Section 121 Exclusion toward the exchange proceeds from that part rather than the whole complex, which means that only the income from the principal residence portion will be eligible for the Section 121 Exclusion. The three remaining units' income would go toward the 1031 Exchange's new property.

Using a 121 Exclusion After a 1031 Exchange

If you convert your replacement property into a principal residence, you can use a Section 121 Exclusion to eliminate some or all of the gain. To do so, you must own the replacement property for at least five years after the Exchange is performed. This is the case even though the property has to be a principal residence for only two years to meet the Section 121 requirement. Once those two criteria are met, the property may be sold, and the Section 121 Exclusion may be applied. 

When applying a Section 121 Exclusion after an Exchange has been performed, the relationship between the number of years the property is used as an investment property relative to how long it's owned overall will determine how much of the gain may be excluded. 

Simply put, you make a fraction where the total number of years that the property was an investment property (non-qualifying use) is the numerator and the total number of years the property has been owned is the denominator. So, suppose the property was owned for five years after the transaction and was a principal residence for four years. In that case, the numerator is the number of years the property had a non-qualifying use (1), and the denominator is the number of years it was owned overall (5). That means ⅕ of the gain would be considered non-excludable. 

The holding requirement on the post-sale side of the 1031 Exchange transaction is do or die. Professional consultation is advised so you don't end up squandering your opportunity for massive savings by converting your investment property into a principal residence too early.

Bottom Line on 1031 Tax Exchanges

You need to understand your long term strategy. Using a 1031 exchange, you might not be able to completely liquidate your portfolio in 10 or 15 years. We love the idea of a 1031 exchange. We encourage any real estate investor we work with to use this tax tool as an effective way to defer capital gains and avoid depreciation recapture. 

Just make sure you are prepared for the pressure of finding a potential replacement property quickly. You need to understand the risk of making bad decisions under pressure and the long term impact on your portfolio.

If you like the Section 121 Exclusion, then you may also be interested in the live-in flip, one of the top strategies to use if you're interested in the best places to invest. It's where your property is your primary residence for two years while you renovate it, and then you use it as an investment for three years before selling it. 

Here are some quick tips to remember when you're considering a 1031 exchange:

  • Start the process of looking for a replacement property as soon as possible. Identify a suitable replacement right away.
  • Consult with a tax advisor. An expert can help you navigate the exchange process and protect you from mistakes.

You can do some other things to reduce your risk, and we'd be happy to tell you about those in more detail. If you have any questions, please contact us at Mynd Property Management.

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