How savvy investors use 1031s to defer capital gains and build wealth Part of the Series Real Estate Investing Guide Real Estate Investing Basics
A 1031 exchange is a swap of one real estate investment property for another that allows capital gains taxes to be deferred. The term—which gets its name from Section 1031 of the Internal Revenue Code (IRC)—is bandied about by real estate agents, title companies, investors, and more. Some people even insist on making it into a verb, as in, “Let’s 1031 that building for another.”
IRC Section 1031 has many moving parts that real estate investors must understand before attempting its use. An exchange can only be made with like-kind properties, and Internal Revenue Service (IRS) rules limit its use with vacation properties. There are also tax implications and time frames that may be problematic.
If you are considering a 1031 exchange—or are just curious—here is what you should know about the rules.
A 1031 exchange can be a powerful tool for real estate investors to defer capital gains taxes on investment property sales. However, these exchanges must follow strict IRS regulations to qualify for tax-deferred status. One key requirement relates to financing rules for 1031 exchange loans.
What is a 1031 Exchange?
First, let’s review what a 1031 exchange entails. This tax strategy allows real estate investors to sell an investment property and reinvest the proceeds into a replacement property while deferring capital gains taxes. The exchange gets its name from Section 1031 of the Internal Revenue Code.
For an exchange to qualify, the relinquished and replacement properties must be like-kind investments. The properties don’t have to be identical, just similar in nature and character. For example, you can exchange a rental house for an apartment building or a retail space for a warehouse.
Why 1031 Exchange Loans Matter
When completing a 1031 exchange, you must reinvest all your profits from the sale into the new property to avoid paying taxes. If you don’t reinvest the full amount any leftover money is considered “boot” and becomes immediately taxable.
This is where 1031 exchange loans come into play. If you need to purchase a more expensive replacement property, you can tap financing to cover the difference. This allows you to reinvest 100% of your equity while borrowing extra funds as needed.
1031 Exchange Loan Rules and Requirements
IRS regulations impose strict requirements regarding 1031 exchange loans:
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Loan must come from third party: The exchange loan can’t come from the seller of the replacement property or anyone else involved in the exchange. It must be an arm’s length loan from a third-party lender like a bank, credit union or mortgage company.
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No selling property subject to existing loans: You can’t transfer loans from the relinquished property to the replacement property. Any existing mortgages or liens must be paid off when you sell.
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Limits on refinancing: You must wait until after the exchange is complete to refinance or take cash-out on the replacement property. Doing so beforehand could generate taxable boot.
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Interest payments don’t qualify: Only the principal portion of exchange loan payments counts toward your reinvested equity. Interest payments don’t qualify.
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Short-term financing only: Exchange loans are usually short-term loans that are refinanced after the exchange. The initial financing period is often limited to 180 days or less.
As long as you follow these requirements, 1031 exchange loans can help you fully reinvest in a replacement property and reap the tax perks. Consult with a lender familiar with 1031 exchanges for guidance on financing rules.
Bridge Loans for 1031 Exchanges
One common approach for 1031 exchange loans is using a bridge loan. This is a short-term financing option meant to “bridge” the gap between selling your old property and buying your new one.
Bridge loans have features that make them suitable for exchanges:
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Fast funding: Bridge loans can fund quickly, often within a week or less. This gives you access to funds when you need it during the tight 1031 timelines.
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Flexible terms: Bridge loans are available from 30 days up to around 2 years. You can match the term to your expected exchange completion timeline.
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Competitive rates: While bridge loans carry higher rates than conventional mortgages, they are lower than other short-term products like hard money loans.
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Large loan amounts: You can borrow large sums with a bridge loan, making it easy to cover any price differential between properties.
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No restrictions on property use: Bridge lenders don’t place limits on how you use the replacement property, unlike cash-out refinancing.
Steps for Getting a 1031 Bridge Loan
If you decide a bridge loan is the right financing approach for your 1031 exchange, follow these key steps:
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Find a lender that offers bridge loans for exchanges. They will understand the unique requirements.
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Apply for pre-approval to confirm you qualify and determine the loan amount.
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After identifying your replacement property, have the lender order appraisals on both the sold and newly acquired properties.
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Finalize the bridge loan paperwork and close on financing before the end of your 180-day exchange period.
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Draw on the bridge loan at closing of your replacement property purchase to reunite your full equity.
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Refinance into long-term financing before the bridge loan matures.
With the right lender and proper adherence to IRS guidance, bridge loans can be an optimal temporary financing solution for 1031 exchanges.
Alternatives to Bridge Loans
Bridge loans are commonly used for 1031 exchanges, but not the only option. Some other potential 1031 exchange loan alternatives include:
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Home equity lines of credit (HELOCs): If you have sufficient equity, a HELOC can provide funds for your exchange. Rates are often lower than bridge loans.
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Hard money loans: These asset-based loans from private lenders offer quick funding but at high rates and potentially burdensome terms.
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Seller financing: In limited cases, the seller may agree to act as lender if you run short on exchange funds. Requirements are strict.
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Retirement account loans: You may be able to borrow against your 401(k) or IRA, but this is very risky and puts your retirement savings at jeopardy.
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Private loans from family/friends: As an absolute last resort, you could pursue personal loans from family or friends. This mixes business with personal relationships.
Unless you have experience with the intricate 1031 regulations, bridge loans tend to be the most prudent loan avenue for investors.
Partnering With a Qualified Intermediary
Navigating 1031 exchange loans while adhering to IRS rules can be challenging. Working with a qualified intermediary (QI) can provide critical guidance.
A QI is an independent third party who coordinates the exchange process. They prepare exchange documents, hold exchange funds during the transaction, and help steer investors clear of pitfalls.
Be sure to choose an experienced QI who is familiar with 1031 exchange financing intricacies. Their expertise can prove invaluable in ensuring your exchange meets requirements.
Consulting a Tax Professional
It’s also wise to consult a tax professional like a certified public accountant (CPA) or tax attorney when using financing in a 1031 exchange. A tax expert can help you:
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Calculate the precise amount you can reinvest without incurring taxable boot.
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Determine how much of your equity must go toward principal on exchange loans.
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Decide which type of financing best suits your scenario.
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Ensure you comply with timing, documentation and other exchange regulations.
The Bottom Line
1031s for Vacation Homes
You might have heard tales of taxpayers who used the 1031 provision to swap one vacation home for another, perhaps even for a house where they want to retire, and Section 1031 delayed any recognition of gain. Later, they moved into the new property, made it their principal residence, and eventually planned to use the $500,000 capital gain exclusion. This allows you to sell your principal residence and, combined with your spouse, shield $500,000 in capital gain, as long as you’ve lived there for two years out of the past five.
In 2004, Congress tightened that loophole. However, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. For example, you stop using your beach house, rent it out for six months or a year, and then exchange it for another property. If you get a tenant and conduct yourself in a businesslike way, then you’ve probably converted the house to an investment property, which should make your 1031 exchange all right.
Per the IRS, offering the vacation property for rent without having tenants would disqualify the property for a 1031 exchange.
45-Day Rule
The first timing rule relates to the designation of a replacement property. Once the sale of your property occurs, the intermediary will receive the cash. You can’t receive the cash or it will spoil the 1031 treatment. Also, within 45 days of the sale of your property, you must designate the replacement property in writing to the intermediary, specifying the property that you want to acquire.
The IRS says you can designate three properties as long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.
What Is A 1031 Exchange & Should You Use One?
FAQ
Can you get a loan on a 1031 exchange?
How does debt work in a 1031 exchange?
What is the 2 year rule for 1031 exchanges?
Can a borrower get cash back on a 1031 exchange?
Can I get a 1031 exchange if I own a business?
If you own business or investment property, then you may be able to benefit from a 1031 exchange. By buying another like-kind property of equal or greater value, you may be able to defer the capital gains tax bill into the future – or avoid capital gains taxes if you die before selling the last property.
What is a Section 1031 exchange?
A Section 1031 exchange involves the exchange of one property for another of like-kind. The simplest type of Section 1031 exchange is a simultaneous swap of one property for another. Deferred exchanges are more complex but allow flexibility and involve disposing of a property and subsequently acquiring one or more other like-kind replacement properties.
How many times can you do a 1031 exchange?
A 1031 exchange allows you to defer your investment’s capital gains tax. There’s no limit on how often you can do a 1031 exchange. You can roll over the gain from one piece of investment real estate to another and another and another. Although you may have a profit on each swap, you avoid paying tax until you sell for cash many years later.
Can a 1031 exchange buy a new investment property?
A new investment property can be bought using a 1031 exchange. Tracy could structure the exchange by having the proceeds from the sale of $3 million be sent directly from escrow to a qualified intermediary. Tracy has 180 days from the finalization of the sale to locate and complete the acquisition of the new investment property.