Learn how 1031 exchanges work in real estate investing and how this tax rule can benefit rental property owners.
A 1031 exchange is a tax break that allows real estate investors to defer capital gains taxes when they sell one investment property and replace it with a like-kind property. Depending on the type of 1031 exchange, investors can then reinvest the deferred tax money from the sale into the new property, repair an existing property, or partially defer their taxes. Keep reading to learn more about how 1031 exchanges work in the world of real estate investing — and how this tax rule can benefit rental property owners.
Navigating real estate investment tax laws can be complex territory. However, it’s important that real estate investors fully understand the tax implications of their purchase decisions and know how to leverage tax rules (like 1031 exchanges) in their favor. This is especially true if you own an investment property and are considering cashing out and buying a similar property.
Here, we break down how 1031 exchanges work, the benefits and limitations of this tax rule, and the different kinds of exchanges you need to know.
Named after Section 1031 of the U.S. Internal Revenue Code, a 1031 exchange is a popular real estate investment tool among landlords who are eager to defer capital gains taxes.
What exactly does this entail? A 1031 exchange allows an investment property owner to defer paying their capital gains taxes when selling their investment property by reinvesting the funds into a similar, or like-kind, property. For this reason, 1031 exchanges are also referred to as like-kind exchanges. By deferring the capital gains tax, or the tax payment you have to make on your asset’s appreciation during the time that you owned it, investors free up more capital to invest in a new property.
Think of it this way: if you bought your home for $150,000 and later sold it for $200,000, your profit ($50,000) represents your capital gain. That $50,000 capital gain is subject to tax — but you can defer paying it with a 1031 exchange. That means you can reinvest the money from this sale into buying another property.
For savvy real estate investors, a 1031 exchange is a powerful tool that can be used time and again. In fact, as long as you’re compliant with IRS rules, there’s no limit on how many 1031 exchanges you can do. Among the most appealing benefits of a 1031 exchange are:
While 1031 exchanges sound relatively straightforward, they are complex transactions that come with a host of regulations and limitations. The criteria for carrying out a successful, compliant 1031 exchange include:
There’s no limit on the frequency of 1031 exchanges, as long as you remain compliant throughout the entire process. 1031 exchanges offer real estate investors a unique opportunity that they can leverage as frequently as they see fit. That said, it’s important to do your due diligence to remain compliant with IRS criteria and avoid unnecessary missteps.
Let’s walk through an example of how a 1031 exchange could work.
Imagine Amelia sells an investment property in Florida for $800,000 on September 1. Because the property’s value appreciated since the purchase date, Amelia’s capital gain is about $100,000.
Following the sale, an intermediary receives the cash and holds it in escrow. Later, they will facilitate moving that money to purchase the replacement property.
Twenty days later, on September 21 (well within the IRS’s 45-day timeline), Amelia completes the paperwork that identifies the new investment property she plans to acquire. The new place in Florida is considered a like-kind property, as defined by the IRS. She sends the relevant documentation to her intermediary.
Fifty days after the sale, on November 10, Amelia closes on her new investment property. Keep in mind: the IRS deadlines for identifying a new property (45 days) and then closing on it (180) run concurrently. In Amelia’s case, she has met both timelines in 70 days and therefore qualifies for the 1031 exchange.
Now, instead of paying taxes on her $100,000 profit at the time of sale, Amelia can reinvest that money into her new property. In other words, Amelia can continue rolling over her gains from one investment property to another, deferring paying that tax until she sells for cash many years down the line. In this case, she will only pay one tax at a long-term capital gains rate in the future.
There are a few different variations of 1031 exchanges that real estate investors should be aware of:
Keep in mind: no matter which 1031 exchange you want to participate in, it’s essential that you consult a professional throughout the process. The last thing you want is to risk a financial misstep or miss a tax error that could result in steep fines or penalties.
When done in compliance with IRS standards and formally filed during the proper tax year, 1031 exchanges offer real estate investors a unique opportunity to build wealth and diversify their portfolios over time. The best part? There’s no cap on how often you can defer your capital gains taxes — as long as you continue following the rules.