Skip to content

Exchange Rules: Basics

Major Topics

What is a 1031 Exchange?

1031 Exchange Basics

Taxes might be an unavoidable part of life, but there are intelligent ways for you to better leverage the taxes you owe to your advantage. With a 1031 exchange, you can maximize your investment potential by deferring certain taxes and increasing the size of your next investment. Learn more about how it works. 

what is a 1031 exchange?

What is a 1031 Exchange?

A 1031 exchange lets real estate investors defer taxes, both capital gains and depreciation recapture, when they sell an investment property. To qualify for tax deferral, the investor must reinvest into a new investment property (hence the term “exchange”).  Moreover, the new asset — or assets — must be “like-kind” replacement property, and the replacement should be of equal or greater value than the older, relinquished property. Essentially, you trade one property for another to qualify for what the IRS terms “nonrecognition of gain or loss.”

In short, the IRS says “As long as you keep using real estate productively, we’re not going to punish you by levying taxes.”

This exchange strategy gets its name from Section 1031 in the Internal Revenue Code. And, in practical terms, a 1031 exchange can be a very powerful tool for building wealth. Whether you’re just beginning to explore real estate investing or have been doing it for years, understanding how to 1031 exchange is key to maximizing your profit and wealth. 

Note that executing a 1031 exchange isn’t a DIY project. To comply with IRS rules, you need a middleman called a Qualified Intermediary (QI) if you want to enjoy the tax deferral benefits. 

Let’s take a closer look and explain the 1031 process:

Imagine this: You purchase a rental property for $300,000. Ten years later, you sell the property for $500,000. This represents a potential taxable capital gain of $200,000, plus you have 10 years of depreciation recapture taxes to deal with. Without utilizing a 1031 exchange, you would likely end up writing a very large check to Uncle Sam (and your state government). But, thanks to using the 1031 exchange strategy, you are able to defer your capital gains tax and recaptured depreciation taxes and reinvest all of your built-up capital.

And here’s the key: Deferring taxes allows you to deploy your wealth more efficiently. You can use the funds that would have gone towards taxes as part of the down payment on the next property. With a bigger down payment, you can afford more, more expensive and/or higher quality properties. In turn, those properties most likely have a higher income-producing potential. You can also switch property classes or invest in a different part of the real estate sector.

Steven W. Hickox, the founder of 1031X, describes the 1031 exchange process as “an interest-free loan from the government.” The extra money that you have access to if you qualify for a 1031 makes a significant difference in your investing decisions. It also dramatically affects your cash returns and can transform your portfolio throughout your investing career.

Why do a 1031 Exchange?

Why do a 1031 Exchange?

Think of the accumulated wealth generated from your real estate investments like snowballs. As a snowball rolls down a hill, it increases in size. But if that snowball hits an obstacle, it will break into pieces and lose momentum. Over time, the properties you own become more valuable. If you manage the real estate appropriately, your portfolio gains more and more momentum. However, once you decide to sell a property, you risk running into obstacles — notably very large tax liabilities — which diminish your opportunities for future profits.  If you could avoid those obstacles, you can keep all of that momentum working for you. 

A 1031 exchange moves those obstacles out of the way. Your investments can continue to grow, unimpeded by taxes. Over the long run, your snowball gets bigger and bigger, rather than being broken up at different times along the way. 

Let’s follow that (silly) snowball analogy:
You make a snowball and roll it downhill. The snowball gets bigger as it rolls.
sales price increasing from purchase price because of appreciation graphic

Unfortunately, there are sharp rocks at the bottom.

(Quick fact: Income taxes are often your largest cost when selling investment real estate)

Not good.

sales price being decreased by taxes graph

But what if you could put your snowball on top of a new hill instead of hitting the rocks?

That snowball keeps growing bigger, faster.

1031X tax benefits graph

You get the point.

1031 exchanges do this for your real estate investments.

You’ll hurdle right over HUGE tax events.

And get tons of benefits.

Benefits of a 1031 Exchange

benefits of a 1031 exchange

The most significant benefit of a 1031 exchange is that it allows your investments to “snowball” and continue to grow. Your profits continue to work for you, rather than being siphoned off to the IRS. Thanks to a 1031 exchange, you can get:

  • Better cash flow: Generate larger monthly rents as you upgrade into bigger, better real estate portfolios.
  • Greater flexibility: While you need to follow the rules to qualify for a 1031, doing so allows you to reallocate your capital without taking a tax hit.
  • Control over taxes: 1031 exchanges don’t eliminate taxes, but they give you more control over when and if you want to realize them.
  • Larger investments: Thanks to the tax deferment, you have more cash to reinvest in a property. You can purchase larger properties, which may have the potential for larger returns. 

How Does a 1031 Work?

how does a 1031 exchange work?

How does a 1031 Exchange work?

A 1031 exchange works by allowing you to swap, or exchange, one property for another with the help of your Qualified Intermediary. To qualify for a 1031, you can’t simply sell your existing property and then purchase another. Instead, you must hire a 1031 company (such as 1031X), sign specific 1031 exchange forms, and follow certain rules.

Legally, the idea is that your 1031 exchange structure creates distance between yourself and the proceeds from your sale, which in turn allows you to avoid recognizing any of those funds as taxable income.

Three types of taxes qualify for deferment through a 1031 exchange:

01

Capital Gains Tax

02

Depreciation Recapture Tax

03

Obamacare Tax (ACA or NIIT)

Capital Gains Tax

You earn capital gains when the sale price of a property is more than your purchase price, minus closing costs. If you buy property for $250,000, sell it for $315,000 and pay $15,000 in closing costs, your capital gains are $50,000.

 

Taxes on long-term capital gains range from zero to 20%, depending on your taxable income and filing status.

Depreciation Recapture Tax

One of the best perks to owning investment real estate is that you get to deduct the cost basis of your property from your income over time. As a result, you pay fewer taxes each year than you otherwise would. On a normal depreciation schedule, can depreciate residential property for 27.5 years and commercial property for 39 years.

The trade-off is that when you sell your property, you need to calculate the sum of your prior depreciation and pay taxes on that amount, usually 25%, on the amount. With a 1031 exchange, you can defer the depreciation recapture tax. 

Net Investment Income Tax (NIIT)

The Affordable Care Act (ACA) introduced the NIIT, a 3.8% tax on investment income when the individual or entity earns above a certain income threshold.

If the income you would earn on the sale of your investment property pushes your income past the NIIT threshold, you can also defer the NIIT through a 1031 exchange.

Keep in mind that almost all state governments also allow you to defer state income taxes with a 1031 exchange.  There are notable exceptions and asterisks here.  For example, Pennsylvania does not recognize 1031 exchanges for state tax purposes (you can still defer federal taxes on the 1031 exchange of a PA asset).  

Some states, like California and Montana, require you to keep track of your potential tax liability across time when you trade out of their state.

Which Properties Are Like Kind?

What is a like-kind property?

Through a 1031 exchange, you sell your original property and trade it for a “like-kind” property. The term “like-kind” can be confusing, as it implies that you need to exchange your investment for one that’s similar. However, the IRS’s rules on the definition of “like-kind” are surprisingly liberal — almost any type of property can qualify as a “like-kind” property. 

The IRS has a very loose definition of like-kind properties, stating that properties are generally like-kind if they are of “the same character or nature, even if their quality differs”. The Treasury Regulation’s definition of “like-kind” is a property that’s used in trade or business or for investment. 

Like-kind properties include single-family homes, multi-family properties, farms, resorts, and commercial buildings. It might be easier to define what doesn’t qualify as like-kind property, namely personal residents and vacation homes.

Do You Ever Pay the Taxes?

Do you ever pay taxes?

Remember that with a 1031 exchange, you defer taxes. This means that at some point, you will need to pay them, at least in theory. But in reality, you can repeat the 1031 exchange process to continue to defer your taxes.  

There are other strategies for escaping your final tax bill (or at least a portion of it), but it’s best to speak with an intermediary and/or your tax accountant about these. 

Limits of a 1031 Exchange

If a 1031 exchange sounds almost too good to be true, remember that it’s not meant to be a magic way to dodge the bullet of taxes. You must follow the processes and procedures to qualify, including identifying your next property within 45 days of closing of your sale.

Other than that, the IRS doesn’t limit the number of exchanges you may execute or the number of properties you sell or buy during an exchange. IRC Section 1031 also doesn’t limit the total tax benefit you can receive.

1031 Exchange Limits

Contact 1031X to start your 1031 Exchange

Contact 1031X to start your exchange

To maximize your tax benefits, it pays to work with a 1031 exchange company that will guide you through the process. Contact 1031X to set up your free consultation or get started with a 1031 exchange in just a few minutes.  

Explore More

Explore More About Exchanges

Learn to Master 1031 Exchanges

Whether you are brand new, or need an advanced strategy, this is your go-to center for Section 1031 Exchanges.