How To Successfully Exchange Investment Properties Using a 1031 Exchange

Investing in real estate can be an excellent way to build long-term wealth. As an investor, you buy properties, improve them, and either flip them for a profit or hold them as rental income properties. But at some point, you may feel ready to exchange one investment property for another one through something called a 1031 exchange.

A 1031 exchange allows real estate investors to swap one investment property for another while deferring capital gains taxes on the sale. This strategic move enables investors to upgrade their rental portfolios over time without losing money to taxes. It can take your real estate investing to the next level!

In this comprehensive guide we’ll explain everything you need to know about 1031 exchanges including

• What is a 1031 exchange
• 1031 exchange requirements
• How to execute a 1031 exchange
• 1031 exchange rules and timeline
• 1031 exchange types
• 1031 exchange tax implications
• 1031 exchange FAQs

Let’s dive in so you can master the 1031 exchange process.

What Is A 1031 Exchange?

A 1031 exchange, also called a Starker exchange or like-kind exchange, allows you to sell an investment property, reinvest the proceeds in a new investment property, and defer paying capital gains taxes on the initial sale.

It’s named after Section 1031 of the Internal Revenue Code, which permits the deferral of capital gains tax when selling one investment property and buying another of equal or greater value. The properties must be “like-kind” real estate investments.

The 1031 exchange is popular among real estate investors looking to move up to bigger, better properties or change their portfolios without losing money to taxes. As long as you follow the rules, you can continue exchanging properties, deferring capital gains indefinitely.

Investment property owners often work with qualified intermediaries to facilitate 1031 exchanges The intermediary handles the sale proceeds and makes sure all IRS regulations are followed

How Does A 1031 Exchange Work?

Generally, when you sell an investment property at a profit, you owe capital gains tax on the difference between your basis (what you paid for it) and the sale price. But a 1031 exchange lets you avoid paying those taxes if you reinvest the proceeds in another eligible property.

Since you don’t receive proceeds from the initial sale, there is technically no taxable gain. You are gaining a new property equal to or greater than the one you sold.

1031 Exchange Requirements

For an exchange to qualify as a 1031 exchange, it must meet several requirements:

• The relinquished property you sell and the replacement property you buy must be qualifying “like-kind” real estate investments. The properties don’t have to be identical, but they should be similar in nature, character, and use.

• You must identify possible replacement properties within 45 days of selling the relinquished property, and you must close on a replacement property within 180 days of selling the relinquished property.

• The combined mortgage debt on the replacement property must be equal to or greater than the debt on the relinquished property to defer taxes on the full proceeds.

• You must use the services of a qualified intermediary to facilitate the exchange.

• You can’t receive any of the proceeds from the sale of the relinquished property during the exchange period. The proceeds must go directly into an escrow account held by the intermediary.

• You must report the exchange to the IRS by filing Form 8824 with your tax returns.

How to Execute a 1031 Exchange

Follow these key steps to successfully complete a 1031 exchange:

1. Find a Replacement Property

First, identify the relinquished property you want to sell and the replacement property you want to exchange it for. Make sure the replacement property is equal to or greater value than the relinquished property.

2. Hire a Qualified Intermediary

A qualified intermediary handles the exchange for you. They sell the relinquished property on your behalf and acquire the replacement on your behalf, following all IRS rules. Choose an experienced intermediary you can trust.

3. Sell the Relinquished Property

Your intermediary sells the relinquished property on your behalf. The proceeds go directly into an escrow account held by the intermediary, not to you.

4. Identify Potential Replacement Properties

You have 45 days after the sale of the relinquished property to identify potential replacement properties in writing to your intermediary. You can designate up to three properties without justification.

5. Purchase the Replacement Property

You must close on a replacement property within 180 days of selling the original relinquished property. Your intermediary delivers the funds from the sale to complete the purchase. The title is transferred to you.

6. Report the Exchange

File IRS Form 8824 with your tax returns informing the IRS of the exchange and describing the timeline and properties involved.

1031 Exchange Rules and Timeline

It’s crucial to follow all IRS rules and meet the strict 1031 exchange deadlines:

• 45-Day Identification Period – You have 45 calendar days after closing on the sale of the relinquished property to identify possible replacement properties in writing to the intermediary.

• 180-Day Purchase Period – You must close on the purchase of a replacement property within 180 calendar days of selling the relinquished property, or by the due date of your tax return (with extensions), whichever comes first.

• Title Requirement – The titles of both the relinquished and replacement properties must be held in the same exact name to qualify, either as an individual or an entity, such as an LLC.

Types of 1031 Exchanges

There are a few different types of 1031 exchanges investors can consider:

• Delayed Exchange – The most common type of 1031 exchange. You sell the relinquished property first, and then have 180 days to close on a replacement property.

• Reverse Exchange – You purchase the replacement property first, before selling the relinquished property. Helpful in competitive markets.

• Improvement Exchange – Sale proceeds go toward improvements on the replacement property within 180 days instead of purchasing another property.

• Personal Property Exchange – Instead of real property, business equipment gets exchanged.

Tax Implications of 1031 Exchanges

While 1031 exchanges allow you to defer capital gains taxes, there are some potential tax implications:

• You may owe depreciation recapture taxes if you claimed depreciation deductions on the relinquished property.

• If you receive cash or “boot” during the exchange, you’ll owe capital gains tax on the boot amount.

• Holding replacement properties for the long-term (over 1 year) results in more favorable long-term capital gains tax rates when you eventually sell.

1031 Exchange FAQs

Here are answers to some frequently asked questions about 1031 exchanges:

Can you do a 1031 exchange with a primary residence?

No, 1031 exchanges only apply to investment properties and business properties held for productive use, not personal homes held for personal use.

How many times can you do a 1031 exchange?

There is no limit. You can continue exchanging investment properties and deferring capital gains taxes indefinitely.

Can you get cash back in a 1031 exchange?

You can receive some cash from the sale proceeds, but will owe capital gains tax on the amount of cash received, known as “boot.” To defer all taxes, you must reinvest all exchange proceeds.

What are the limits on number of properties identified?

You can identify up to three potential replacement properties without justification. To identify more, certain rules apply. Check with your intermediary.

Can you exchange property owned free and clear?

Yes, paying off the mortgage on the relinquished property doesn’t disqualify the exchange as long as other rules are followed.

Can you do a 1031 exchange across states?

Yes, geographic location does not matter as long as both properties are located within the United States.

Wrapping Up on 1031 Exchanges

As you can see, a 1031 exchange can be extremely useful for real estate investors looking to build and improve their rental property portfolios. Following the requirements closely and working with an experienced intermediary sets you up for a smooth transaction.

While 1031 exchanges defer your taxes, it’s wise to consult your accountant or tax advisor before initiating one. You’ll also want to work with real estate and legal professionals to ensure you meet all deadlines and comply with state and federal regulations.

If you decide to finance the purchase of your replacement property, the experienced team at Investment Property Loan Exchange can match you with top national and regional lenders that specialize in investment property loans. We provide access to competitive financing options to successfully grow your rental property portfolio over time.