1031 Exchanges: A Guide for Real Estate Investors

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.

What is a 1031 exchange?

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.

What are the benefits of a 1031 exchange?

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:

Greater cash flow
Increased purchasing power
Lower income taxes
A diversified investment portfolio

What are the criteria for a 1031 exchange?

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:

Proceeds from the sale must be held in escrow by a third party. When you sell your investment property, money from the sale must be held in escrow by a third party. Then, it must be used to buy the new replacement property. In other words, you cannot receive the cash in your bank account — even temporarily.

Properties exchanged must be considered like-kind by the IRS. In the context of a 1031 exchange, the investment property you sell must be similar to the one you replace it with. Under Section 1031, a like-kind property is classified as one held for investment, trade, or business purposes. The IRS offers these examples for clarity: “An apartment building would generally be like-kind to another apartment building. However, real property in the United States is not like-kind to real property outside the United States.”

Properties must have a similar function. Similar to the like-kind point, both properties involved in the exchange have to serve the same purpose. For example, you can’t exchange an investment property for a personal vacation home. Personal residences do not qualify as like-kind properties and cannot be exchanged under this tax rule.

A replacement property must be identified in writing within 45 days. The timelines associated with 1031 exchanges are firm. Once you sell your property, a third party will hold the cash for you. Then, within 45 days, you must identify in writing the replacement property you intend to acquire.

A new property must be acquired within 180 days. In the same vein, once you have it in writing that you are selling one property and buying a new one, you must close on the new property within 180 days of the sale.

The IRS must be notified in the appropriate tax year. If you’re doing a 1031 exchange, you have to compile the right paperwork and submit Form 8824 with your tax return in the year the exchange occurred.

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.

How does a 1031 exchange work?

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.

What are the different types of 1031 exchanges?

There are a few different variations of 1031 exchanges that real estate investors should be aware of:

Delayed 1031 exchange. This is the example used above with Amelia’s investment property. The 1031 exchange is delayed when investors have 45 days to identify the property they plan to acquire, and then 180 days after the sale to close on a new property.

Partial 1031 exchange. Some investors may opt to reinvest only a portion of the funds from their sold property into the replacement property, meaning they can only defer a portion of the taxes rather than all of it. The portion of the exchange proceeds that are not reinvested is subject to capital gains taxes.

Reverse 1031 exchange. This is the opposite of a delayed 1031 exchange. Here, real estate investors can opt to acquire a like-kind property first and relinquish their old property second.

Improvement 1031 exchange. In this type of exchange, real estate investors can sell their property, defer taxes, and use the profits to make improvements to an existing property in your portfolio, construct a new property, or renovate the replacement property.

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.

Maximize your real estate investment with a 1031 exchange

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.