1031 For Dummies

1031 Exchange: A Full Guide

October 8, 2024 • 10 min read

What are "normal" 1031 exchange investment options?

Defer capital gains tax on real estate investments using 1031 Exchange.

A 1031 exchange is a tax strategy that allows you to sell one investment property and buy another without immediately paying taxes on the sale. If you want to keep building your real estate portfolio without losing profits to taxes, this is one of the best ways to do it. We’ll break down the essential rules and concepts in plain language, so you can understand it clearly without being an expert.

Keep in mind that even if you learn these concepts, the IRS rules require you to use a qualified intermediary to conduct your exchange.

How a 1031 Exchange Works

In a normal property sale, you’d sell a property, and any profit would be taxed immediately. A 1031 exchange lets you defer those taxes—meaning you’ll pay them later—by reinvesting the entire profit into a new property. This way, your investment keeps growing, tax-deferred, which can mean bigger opportunities for long-term wealth building.

Think of it as rolling over the profits from one property into another, keeping your investments compounding without taking a tax hit in between.

Key point: A 1031 exchange only defers (delays) taxes; it doesn’t eliminate them unless special circumstances occur, like passing the property to heirs with a tax break.

When You Sell: Taxes Without a 1031 Exchange

Here’s a closer look at what taxes could hit you when you sell a property without using a 1031 exchange:

Capital Gains Tax: This is the tax on the profit you made by selling a property for more than you paid for it. The rate is generally 15–20%, depending on your total income and how long you held the property. Long-term capital gains (on properties held for more than a year) are typically taxed at lower rates than short-term gains.
Depreciation Recapture: Even if you never claimed depreciation on the property, the IRS assumes depreciation occurred over time and will tax you on the recapture of that depreciation. This is taxed at a flat rate of 25% on the total depreciation amount. For real estate investors, this can add a significant amount to the total tax owed.
State Capital Gains: States have their own capital gains tax rates, which can range from 0% to 13%, depending on where the property is located and where you live. This is in addition to the federal capital gains tax.
Net Investment Income Tax (NIIT): Often called the "Medicare surtax," this 3.8% tax applies to investment income, including real estate sales, if your modified adjusted gross income (MAGI) exceeds 200,000 for single filers or 250,000 for married couples filing jointly. The NIIT is meant to help fund Medicare, but it directly affects high-income earners by increasing their tax liability on investment profits.
Alternative Minimum Tax (AMT): In some cases, the AMT could apply, especially if the taxpayer has large deductions, including accelerated depreciation. The AMT ensures high-income earners pay at least a minimum level of tax, recalculating your taxable income and removing some deductions and credits.

Example:

Let's say Chris sells his apartment building, which he bought for $100,000 and sells for $250,000.

Here's a simplified breakdown of his taxes:

Tax Type	Amount
Federal Capital Gains (15%)	$22,500
Depreciation Recapture (25%)	$20,000
State Capital Gains (5%)	$7,500
NIIT (3.8%)	$5,700
Total Tax Liability	$55,700

Without a 1031 exchange, Chris would owe over $55,000 in taxes. But if he reinvests using a 1031 exchange, he can defer all these taxes—meaning he won't have to pay them until he eventually sells the replacement property.

Tangible Benefits of a 1031 Exchange

The main reason investors use a 1031 exchange is to keep their money working for them. By deferring taxes, you can use the full value of the sale to buy a larger or better property, which can lead to:

More cash flow: With a bigger property or more valuable assets, you could see higher rental income or returns.
Property diversification: You can swap into different types of properties (e.g., moving from a small apartment to a commercial building).
Tax deferral: You’re only taxed when you sell and don’t exchange, giving you control over when you pay taxes.

This strategy keeps your investments growing tax-deferred and helps maximize your overall wealth by avoiding an immediate tax hit.

The Step-Up in Basis: An Opportunity to Eliminate Taxes

If you hold onto a property you acquired through a 1031 exchange until your death, your heirs can get a step-up in basis. This means the property's value resets to the fair market value at the time of your death, potentially eliminating the deferred taxes.

For example, if your replacement property was worth $500,000 at the time of your death, but you only paid $300,000 for it, your heirs would receive the property at a new tax basis of $500,000—eliminating the deferred taxes on that $200,000 gain.

This is one way a 1031 exchange can become a permanent tax avoidance strategy, provided your heirs receive that "stepped-up" basis.

The Role of the Qualified Intermediary (QI)

One of the most important rules in a 1031 exchange is that you can’t handle the money yourself. A Qualified Intermediary (QI) is a third-party that facilitates the process for you. Here’s what they do:

Hold the proceeds from the sale of your old property.
Use those funds to buy your new property.

By doing this, the IRS treats the process as an “exchange” rather than a sale. If you touch the money directly, the IRS will consider it a sale, and you’ll have to pay taxes.

Reverse Exchange Tip: If you need to buy the new property before selling the old one, a reverse exchange might be an option. This is more complex but can work in certain situations.

The 45-Day and 180-Day Rules

Timing is critical in a 1031 exchange. You have strict deadlines to follow:

45 Days to Identify: After selling your old property, you have 45 days to identify potential replacement properties. You can list up to three properties, or more if their combined value doesn’t exceed 200% of your sold property’s value.
180 Days to Close: You must close on one of the identified properties within 180 days of selling your old property.

Example:

Chris sells his apartment building on January 1. By February 15 (45 days), he must provide a list of up to three potential replacement properties. By June 30 (180 days), he must have closed on one of those properties.

Important Note: If you miss these deadlines, the exchange fails, and you’ll owe taxes on the sale. Be sure to ask your QI about a "backup plan."

In a 1031 exchange, the 45-day identification period is critical because once that window closes, you’re locked into the properties you identified. Even if you are confident in acquiring a specific property, it’s a smart move to list additional "backup" properties, like Delaware Statutory Trusts or Tenant-in-Common investments, as a safeguard. These types of predictable replacement properties can help ensure that the exchange remains valid if your primary choice falls through for any reason.

Adding these backups can provide flexibility and protect against unexpected issues, like financing delays or sellers backing out.

What Counts as "Like-Kind" Property?

A common misconception is that "like-kind" means the properties need to be similar, but that’s not the case. Almost all real estate is considered like-kind to other real estate as long as both properties are for business or investment purposes. This includes:

Apartment buildings
Office buildings
Shopping centers
Farms or ranches
Vacant land
Industrial properties

But it goes further than just these basics. You can also exchange for specific investment structures like:

Delaware Statutory Trusts (DSTs): These allow you to own a fraction of large, professionally managed real estate, like commercial buildings or multi-family complexes.
Tenant-in-Common (TIC): In this structure, you share ownership of a property with other investors. Each owner holds an undivided interest, which can qualify for a 1031 exchange.
Triple Net (NNN) Leases: A popular choice for 1031 exchanges, this involves properties where the tenant pays not only rent but also property taxes, insurance, and maintenance. Common examples include standalone retail properties like fast-food chains or convenience stores.

What doesn’t count: Primary residences and vacation homes generally don’t qualify for a 1031 exchange unless they meet specific, strict rules.

Holding Period: How Long Should You Own the Property?

The IRS doesn’t give a specific time frame for how long you must hold onto a property to qualify for a 1031 exchange, but the general rule is that two years or more is considered safe. Holding the property for less time could be risky unless you have clear evidence that your intent was to hold it as an investment.

Tip: If you’ve rented out a property or made significant improvements, this could help show that your intent was to hold the property as an investment.

Same Taxpayer Rule: Who Needs to Own the Property?

The person or entity selling the property must be the same one buying the new property.

Here’s what that means:

If you own the property through a single-member LLC or living trust, you’re considered the taxpayer. You can buy the replacement property in the same LLC or in your individual name.
If you own the property with a partner in a multi-member LLC, the LLC must buy the new property—not you individually. Otherwise, the exchange won’t qualify.

Workaround: Some investors use a "drop and swap" technique, converting their ownership into a direct interest in the property before the exchange to avoid this issue.

Avoiding “Boot” and Deferring All Taxes

To defer all taxes, you must reinvest in a property that’s at least equal in value to the one you sold. You also need to replace any debt on the sold property with either new debt or cash. If you don’t do this, you’ll receive boot, which is cash or debt relief, and be taxed on that portion.

Example:

Chris sells his apartment building for $250,000. He had $150,000 in debt and $100,000 in net proceeds. To avoid boot, he needs to buy a new property worth at least $250,000 and take on at least $150,000 in new debt (or contribute additional cash), or he'll be taxed on the difference.

Consult with a 1031 Exchange Specialist

If you're considering a 1031 exchange to grow your real estate portfolio or defer taxes on a property sale, it's essential to have the right guidance. A Qualified Intermediary (QI) is required by the IRS to handle your exchange, and their expertise can help ensure everything goes smoothly.

Working with a QI can prevent costly mistakes and ensure you follow all the IRS rules and deadlines. While I'm not affiliated with any specific QI, it's highly recommended that you consult with a professional who specializes in 1031 exchanges to explore your options and make sure your exchange is executed properly.

Take the next step by reaching out to a trusted 1031 exchange specialist to discuss your unique situation. With the right guidance, you can make informed decisions and maximize the benefits of this powerful tax-deferral strategy.