What is a 1031 Exchange?

With any type of investing, it's important to think about taxes, as that affects your net returns. One strategy often used in real estate investing to reduce the impact of taxes is to make a 1031 exchange, also called a like-kind exchange. Doing so enables you to sell one property and buy another, potentially without having to pay capital gains taxes at the time of the sale — although the taxes are deferred rather than eliminated.

Still, this tax strategy can be a useful way to gain benefits like increased purchasing power, rather than seeing a good chunk of your profits go to taxes as you're trying to build up your portfolio.

What is a 1031 exchange?

A helpful tax strategy

A 1031 exchange is a tax-advantaged process that involves swapping one kind of real property (i.e., real estate) for another, provided that's for business or investment purposes. Named after Section 1031 of the U.S. Internal Revenue Code, these exchanges allow the participant, which can be an individual or entity, to defer taxation on the property sold as long as the proceeds are used toward a like-kind investment within a certain timeframe — generally 180 days, but there are additional 1031 exchange rules and nuances to consider.

That said, what qualifies as like-kind is pretty broad. It's not necessarily about replacing one plot of land with another of similar size and value, for example. Instead, it's more about exchanging one type of real estate for another, except you can't exchange U.S. property for foreign property.

As Adam Kaufman, co-founder and chief operating officer of real estate crowdfunding platform ArborCrowd, explains: "By using 1031 exchanges, real estate investors are able to sell a real estate asset and reinvest the proceeds into a like-kind investment — another real estate asset — and defer the capital gains tax associated with the transaction."

In other words, instead of having part of your real estate capital gains taxed when selling, you can potentially roll all the proceeds into a new investment. While you may owe taxes down the road, deferring them can provide many benefits, such as giving you more purchasing power to buy an investment property you think could generate higher returns.

1031 exchange rules: What investors need to know

To understand how to do a 1031 exchange, it's important to understand the main components, including the following:

"Like-kind" property

There are some very specific 1031 exchange rules that investors must follow if they want the benefits of these swaps. First of all, properties must be the same type or "like-kind" to be involved in a 1031 exchange. However, the IRS defines this term broadly, stating that: "Properties are of like-kind if they're of the same nature or character, even if they differ in grade or quality."

Moreover, a 2008 IRS fact sheet specifies: "Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land."

The fact sheet goes on to highlight a few exceptions, such as how you can't exchange property in the U.S. for property outside the county. Also, you can't exchange land for improvements sold without the underlying land.

For example, selling a plot of land and then buying an office building that's sold on top of leased land generally wouldn't qualify for a 1031 exchange.

Note: The Tax Cuts and Jobs Act from the first Trump administration changed 1031 exchange rules so that it only applies to real property, not personal property or intangible property (e.g., copyrights or patents).

Using a qualified intermediary

A key part of meeting IRS rules for a like-kind exchange is that the seller can't take possession of the sale proceeds; the funds need to be held by a third party and then applied to the new purchase. So, those who engage in 1031 exchanges typically use what's known as a qualified intermediary, who acts as a third party to the transaction in order to hold the proceeds of any property sold and use these funds to purchase the replacement property. The qualified intermediary can also help keep you on track for other requirements like deadlines to identify a replacement property and complete the exchange.

1031 exchange types and time restrictions

Technically, there are several types of 1031 like-kind exchanges, including delayed exchanges, built-to-suit exchanges, reverse exchanges, and others.

The exact 1031 exchange process depends on the type you're using, but no matter what type you are using, there are specific 1031 exchange timelines and deadlines to consider.

Delayed exchanges

Most 1031 exchanges are delayed exchanges, which work like this: First, you'd determine the property you want to sell, and identify the exchange facilitator/qualified intermediary you want to handle the transaction.

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This intermediary holds the proceeds of your sale until you've identified the property or properties you'd like to purchase. After the sale, you have 45 days to find potential replacement investments, which need to be documented in writing, and then you have 180 days from the date of the original sale to make a new purchase.

Build-to-suit exchanges

A build-to-suit 1031 exchange allows an investor to use the proceeds of their property sale to not only purchase a new investment but fund improvements on the replacement property, too. The details can be a little trickier than with a delayed exchange, such as with the inclusion of an Exchange Accommodation Titleholder (EAT), often via the qualified intermediary, who holds title on the replacement property while funds are dispersed for improvements.

Also, the improvements have to be done prior to the exchange date — still within 180 days — in order for the value to count toward the exchange. Otherwise, you might end up in a situation where the value of the replacement property is less than what you sold the other one for, creating a taxable portion known as the boot.

Reverse exchanges

In a reverse exchange — which can be a subset of a build-to-suit exchange but also its own transaction — the replacement property is purchased first, and then the initial property is relinquished afterward.

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As in a delayed exchange, both steps must occur within 180 days. And like with a build-to-suit exchange, you'd use an EAT to facilitate title changes so that you're not running afoul of IRS rules by owning both the replacement and original property at the same time.

1031 exchange benefits: Why real estate investors use them

These swaps may sound complicated, but there are many reasons you might engage in 1031 exchange real estate strategies.

One major draw is deferring capital gains taxes on the sale of a real estate property. By using one of these swaps, an investor might be able to build wealth more quickly.

For example, instead of paying a 15% long-term capital gains tax rate when selling a property for a gain of $1 million, thereby leaving you with $850,000, you might put that full $1 million into a new investment property. If that $1 million grows by 10% the next year, that adds $100,000 in value to reach $1.1 million, as opposed to a 10% gain on $850,000 adding $85,000, which would bring the total to $935,000.

Later, if you then paid taxes on that $1.1 million at 15%, that would cost $165,000, bringing the total value to $935,000. In contrast, if you paid the same tax rate on that $85,000 gain in the other scenario, the total value would equal $922,250. Over time, this can add up to substantial differences, but the main point is that deferring taxes via 1031 exchange investment properties can ultimately enable you to build up your net worth, especially if you'd otherwise be paying short-term capital gains taxes that are at much higher rates.

Another significant perk is using one of these exchanges to diversify one's portfolio. By using a 1031 exchange, an investor could swap one kind of real estate property for another, without having taxes hamper this strategy in the near term.

"In a typical real estate transaction, an investor can expect to pay as much as 40% of the taxable gain," says Paul Getty, president and chief executive officer of financial advisory First Guardian Group. "Now, with a 1031 exchange and with the ability to defer those capital gains taxes, investors can seek out a different sort of investment, diversify their holdings, expand their portfolio, or realign their investments with their long-term goals."

You can also use a 1031 exchange to buy a property with better cash flow or gain some benefits from depreciation. Depreciation essentially allows you to pay less in the way of taxes as a property experiences wear and tear over time. For residential rental properties, the benefit is gradually spread out over 27 ½ years.

Typically, if you used depreciation to your advantage, then you'd owe what's known as depreciation recapture — or income taxes on the financial gains you realized from doing so — once you sell the property. Using a 1031 exchange can allow you to push these payments out to a later date.

While deferring these taxes is a nice benefit, 1031 exchanges aren't free. You'll still owe a variety of closing costs and other fees for buying and selling a property. Many of these may be covered by funds stemming from the exchange, but there's debate around exactly which ones. To find out which costs and fees you may owe for a 1031 exchange transaction, it's best to talk to a tax professional.

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