How Does a 1031 Exchange Work?

In This Article

One of the most widely known tax hacks in the real estate investing world is the 1031 exchange.  Chances are, if you’ve read the famed Rich Dad, Poor Dad, like countless other real estate investors across the country, you’ve heard of this wonderful provision in the tax code.

For those who haven’t heard of this powerful strategy, it gets its namesake from Section 1031 of the Internal Revenue Code (IRC). This particular section of the IRC allows a real estate investor to sell a property and defer capital gains so long as the proceeds from the property are reinvested into a different property. The trade-off for using this powerful tool is that there are some hoops that you have to jump through to ensure compliance with the law.  

We’ll dive into everything you need to know about exactly how a 1031 exchange works. We’ll even go through a detailed example of a 1031 exchange scenario that’s probably applicable to some people reading this article.

What Is a 1031 Exchange?

A 1031 exchange is a type of real estate transaction that allows you to defer paying capital gains taxes on a property that you sell so long as you reinvest the proceeds of the property’s sale into another like-kind property. To complete an exchange, you must identify a specific property you want to exchange it for and follow a number of rules in the process (which we’ll cover in a bit). 

There are several types of 1031 exchanges: forward, reverse, and improvement exchanges.

The forward 1031 exchange

A forward 1031 exchange is probably the type of 1031 exchange you’re most familiar with—these are the most commonly used, straightforward types of 1031 exchange. 

In a forward exchange, you sell your property, identify replacement properties, and then purchase one of these properties in that order. Potential replacement properties must be identified within 45 days of selling the relinquished property, and the entire transaction needs to be completed within 180 days of the initial sale. 

The reverse 1031 exchange

The reverse 1031 exchange is a bit different in that, well, everything is reversed. Instead of starting the process by selling a property, you first purchase the replacement property. Once the replacement property is purchased, you have 180 days to complete the sale of the relinquished property in order for the exchange to be valid.  

Reverse exchanges are less common but are often quite handy in a seller’s market when a great deal pops up and you’re not ready to sell your property quite yet.

The improvement 1031 exchange

Another great way to take advantage of Section 1031 is the improvement exchange. This type of 1031 exchange allows you to use the tax-deferred proceeds of the sale of your property to make improvements (as the name would suggest) to the replacement property.  

Improvement exchanges typically work similarly to a forward exchange, with the one major difference being that you don’t just have to purchase the property within 180 days. You also have to identify (and complete) all the improvements that the sale proceeds will be paid for within that same window.

1031 Exchange Rules and Regulations

Regardless of which type of exchange you decide to do, there are some standard 1031 exchange rules you need to follow in order to successfully defer your taxes. Here are some of the most prominent rules and regulations to give you a quick primer. 

What qualifies for a 1031 exchange?

The first, most basic rule is that the transaction you’re doing must qualify for a 1031 exchange.  The property you’re selling must be used for business or investment purposes. 

This means primary residences are not able to qualify for a 1031 exchange. Additionally, properties held in inventory are not eligible for a 1031 exchange (this mainly applies to real estate developers).  

One pro tip: If you have a vacation home you rent out for fair market value at least 14 days per year, and you stay at that home for less than 14 days per year (or 10% of the time the property is rented out, whichever is greater), your vacation home is eligible for a 1031 exchange.  

The like-kind property rule

Another rule that must be abided by is the like-kind property rule. This rule often confuses people, as they interpret “like-kind” to mean that they must buy another hotel if they are selling an existing hotel through a 1031 exchange; however, this isn’t the case. The like-kind rule states both the relinquished property and the replacement property must have the same territory and purpose.  

This means if you are selling a property in the U.S., you must replace it with another property in the U.S. Additionally, if you’re selling an investment property, you cannot replace it with a property that will be used as an office for your business. Instead, you must replace it with another investment property.

Prior to the Tax Cuts and Jobs Act in 2017, this rule used to be more strict on what’s considered “like-kind,” but for now, all real estate is considered like-kind to all other types of real estate. 

The same taxpayer rule

By the same token, you must also abide by the same taxpayer rule. This rule simply states that both the relinquished property and the replacement property must be sold/purchased through the same taxpayer. This helps the IRS ensure there is continuity of investment. If the parties selling the relinquished property and buying the replacement property are different, your 1031 exchange will automatically be disqualified.

If, like most investors, you own property as an individual, in a trust, or in an LLC, this is usually very easy to navigate.

Avoiding constructive receipt

In a 1031 exchange, it’s crucial to avoid what’s known as “constructive receipt” of the sale proceeds to ensure you can defer taxes. Constructive receipt happens when you, or someone acting on your behalf, has control over the money from the sale of your property before the exchange is complete. 

This doesn’t just mean physically holding the money; it also includes situations where the money is available for you to use, even if you haven’t actually touched it.

For example, if the title company sends you a check for the proceeds from the sale of your property, you are considered to have constructively received the money. This would disqualify your 1031 exchange because the IRS sees it as having control over the funds.

To successfully complete an exchange, the law says you must use a qualified intermediary to handle the funds. This party will hold the proceeds from the sale and ensure you don’t have access to them until the replacement property is acquired. This way, you maintain the tax-deferred status of your exchange and avoid any issues with constructive receipt. 

The 45-day identification period

One of the most important regulations in a 1031 exchange is the 45-day rule, which states you have 45 days to identify your replacement property/properties when doing a forward exchange. The 45-day period starts ticking the day you sell your property, ending at midnight on the 45th day.  

The law adds some hurdles when it comes to identifying property, making it clear that an exchange is being performed and investors do not have an open-ended ability to delay their tax bill. Having a basic understanding of these rules will help you plan for a successful exchange. 

The identification rules

When doing a forward 1031 exchange, you need to identify potential properties that you may purchase after the sale of the relinquished property.   

You can’t make a simple mental note that you might be interested in purchasing said property. Instead, you must submit a signed letter that identifies it as a potential replacement property and includes all the pertinent property details. The regulations say this signed letter must then be delivered to someone who isn’t the taxpayer or another disqualified person before the end of the 45-day identification deadline. The person this letter is typically delivered to is the qualified intermediary.

There are also rules around how many properties you can identify and how many you need to purchase as part of your exchange:

• The three-property rule: This states that when you’re performing a 1031 exchange, you can identify up to three potential replacement properties of any value. You can then purchase any single property or combination of properties to fulfill the exchange requirements.
• The 200% rule: If you decide to identify more than three potential replacement properties, the cumulative fair market value of these properties must not exceed 200% of the fair market value of the property you’re selling. To fulfill exchange requirements, you can purchase any single property or a combination of these properties as replacements.
• The 9% rule: Lastly, the 95% rule applies if you do not meet the conditions laid out in the above two rules. If you identify more than three properties and their cumulative value exceeds 200% of the value of your relinquished property, then under the 95% rule, you must purchase 95% or more of the identified replacement properties before the end of the exchange. As you might have guessed, this rule is very seldom used, but still very important.

The 180-day purchase period

The other important timeline you’ll have to adhere to is the 180-day purchase period. This rule states you have 180 days from the date you sold the relinquished property to complete your 1031 exchange. It means you have to identify properties, make a deal, and close on the new property/properties, all within 180 days!

State-specific rules and regulations

As if things couldn’t get more complicated, it’s important to note that all these rules and regulations are federal rules and regulations. Many states have their own rules and regulations that need to be followed in addition.  

States like California have complex 1031 exchange rules. Others, like Arizona, have fewer rules and states like Florida, Texas, and Nevada don’t have income taxes, so there typically aren’t any state-level gains to defer.

A good, qualified intermediary can help you and your tax professional navigate the withholding and filing requirements at the state level. 

What Is a Qualified Intermediary?

Your qualified intermediary is a unique, important part of your 1031 exchange team. They will act as the facilitator for your exchange, ensuring your exchange moves along according to schedule and that you don’t receive constructive receipt of the funds at any point throughout the transaction.  

Qualified intermediaries have to meet stringent requirements laid out by the IRS, which is why investors tend to work with firms that specialize in being qualified intermediaries for 1031 exchanges, like Deferred.  

Who can be a qualified intermediary?

The IRS says a qualified intermediary is required to be an independent party that is impartial to the transaction. The rule of thumb here is that anyone who has acted as a taxpayer’s “agent” within the two years leading up to the exchange cannot be a qualified intermediary. This means your friends, relatives, attorneys, accountants, and real estate brokers do not meet the standards to be your qualified intermediary.

1031 exchange fees: What does it cost?

Although qualified intermediaries used to be very expensive, costs are actually coming down.  It’s a little-known secret that qualified intermediaries charge a fee, but they earn most of their revenue from the interest earned while holding your funds. 

Companies like Deferred offer no-fee exchanges and, in many cases, even share the interest generated from holding your money during the exchange. Based on our 2021 survey, the median cost for a forward exchange was $950. 

A 1031 Exchange Example

To illustrate how a 1031 exchange works, we’ve outlined a case study of a simple forward exchange. This example is a scenario countless real estate investors run into every year.

Purchasing a property

For the sake of this example, we’ll say that a real estate investor named Adam gets his start in the real estate game by purchasing a $500,000 duplex in the great state of California. To purchase the property, he puts $100,000 down and gets a mortgage of $400,000 to cover the rest of the purchase price. This means his property cost basis starts off at $500,000.  

Owning, operating, and depreciating your property

After Adam purchased his property, he rented it out to two great tenants and collected rent from them every month throughout his ownership of the property. 

Let’s say that Adam held on to the property for six years and was able to depreciate it by 20% (a rough estimate for easy math later on). Since he depreciated the property by 20%, his new cost basis on the property is $400,000.

Although Adam enjoys being a landlord, he’s ready to step his game up to the next level. His property has appreciated quite a bit over the past six years, and it’s now worth $1 million, so he’s keen on selling it to finance the next one.  Adam then starts looking around for a larger six-unit property that’s in the $1.5 million price range.  

Calculating the tax implications of a traditional sale

Throughout his research and due diligence, Adam realizes he’s got a bit of a problem: If he sells his duplex using a traditional sale, he’ll owe a lot of money to both the IRS and the state of California.  

Since his property has appreciated so much and he’s depreciated the property by 20%, he finds out that he’ll have $500,000 in capital gains and $100,000 in depreciation recapture to pay taxes on if his property sells for $1 million. His potential tax bill for a traditional sale is as follows:

• Federal depreciation recapture tax (25%): $100,000 x 25% = $25,000
• California depreciation recapture tax (9.3%): $100,000 x 9.3% = $9,300
• Federal capital gains tax (assuming 35% bracket): $500,000 x 35% = $175,000
• California capital gains tax (assuming 13.3% bracket): $500,000 x 13.3% = $66,500
• Net investment income tax (3.8%): $600,000 x 3.8% = $22,800

This would bring Adam’s total tax bill to a whopping $298,600 on a $1 million sale and paying off the $400,000 mortgage, which leaves him with $301,400 after paying both his tax bills, nearly cutting his net proceeds in half. Using his $301,400 in proceeds as a 20% down payment can still get Adam to his $1.5 million target purchase price, but it would be tight.

Instead, he can use a 1031 exchange to defer his capital gains taxes and reinvest all $600,000. This means he can put 40% down on a $1.5 million purchase and increase his cash flow. He would also have the option to scale up to a $3 million property if he found something great, giving him a lot of flexibility. 

Performing the exchange

Once Adam has a plan in place, he gets the ball rolling and works to complete his exchange. 

Assemble the 1031 exchange team: Now that Adam has crunched the numbers on the sale of his existing property, he decides the 1031 exchange is the way to go, so he informs his real estate agent, real estate attorney, and accountant that he’ll be using a 1031 exchange to sell his property. He does this just to make sure everyone is on the same page and well-informed.  

Adam then does some due diligence and seeks out a great qualified intermediary (QI) after realizing that they are one of the most important pieces in the 1031 exchange puzzle, and sets up some meetings to interview prospective QI firms.  

Sell the relinquished property: Now that Adam has all his ducks in a row, he starts the selling process for his existing property. He lists the property and receives an offer for the $1 million he was expecting to sell it for. He graciously accepts the offer and informs his team of the prospective closing date.  

His QI takes possession of the sale proceeds, collects their fee from the deposit, and patiently waits for Adam to find his next property while the QI earns interest.

The 1031 exchange and identifying potential replacements: When Adam closed on his duplex, that started the 45-day identification window. He knows he doesn’t have a lot of time, so he and his real estate agent started touring properties before his sale closed. 

He found several six- and eight-unit properties in the same neighborhood where he sold his duplex. They crunch the rental numbers and find three fantastic potential replacement properties. He then informs his QI of these properties promptly and in writing and starts making some offers.

Completing the exchange: Adam decides he wants to go bigger with the extra cash in hand, and after some negotiation, his $2 million offer is accepted on an eight-unit property! He works with his inspector and loan officer to clear his contingencies and, with his funding in place, moves to close on the property on day 120. Closing goes off without a hitch, leaving Adam with more rental units, more cash flow, and an extra $300,000 in his pocket from deferring his taxes.