Real estate provides excellent opportunities for investors seeking diversification and long-term appreciation. But the asset class presents unique challenges and complications as well. Many tools and tricks are available to real estate investors looking to protect what they’ve put into their properties. Unfortunately, the techniques that provide the greatest rewards are often obscure, opaque, and difficult for investors to properly use. But opportunities exist for those willing to look—and to do the work necessary to fully benefit from them.

One major challenge in real estate comes when one is selling an investment property. Sellers are obligated to pay capital gains taxes on any profits from the sale, even if they weren’t the original purchaser when inheriting property. With some properties, sellers can even be on the tax hook for an investment on which they have lost money. This can be due to bad planning, bad investments, or, just as often, plain old bad luck. Whatever the circumstances, investors do have options for deferring these capital gains. Partnering with licensed professionals, especially those that have a well-documented track record of experience in the nuances of 1031 Exchanges, will help ensure that you evaluate all options and make the most informed decisions.

The 1031 Exchange: What Is It?

Also known as a “Starker exchange” or a “like-kind exchange” (we explain “like-kind” in more detail later), a 1031 exchange allows investors to defer capital gains tax realized by selling an investment property by purchasing another, like-kind property with the proceeds from the sale.

A 1031 exchange can offer an immense advantage, enabling an investor to postpone indefinitely a large tax bill but still make needed changes to their real estate portfolio. For example, a 1031 exchange might allow someone to diversify their real estate holdings, upgrade from a dilapidated property to one with greater future potential, exchange a personally managed rental property for one more easily managed by professionals, or sell a property in one location and purchase one in another. A 1031 exchange can also be a powerful tool for estate planning because investors can use them to position their portfolios for tax-wise generational transfers.

These exchanges must occur under specific circumstances and within a limited window of time, and their feasibility can be determined only on a case-by-case basis. The individual attention of a tax or real estate professional with 1031 exchange experience is invaluable in this process. These experts are able to examine an investor’s position and determine whether an exchange makes sense for them and if so, how much they could potentially benefit.

The 1031 Exchange: Types and Choices

One

Simultaneous Exchange

The most straightforward version of the 1031 exchange is also the least common. In a “simultaneous exchange,” an investor simply transfers their property to someone who owns a “like-kind” property that they want to buy, and this secondary party, in turn, transfers the investor’s property. This seems simple enough, but in practice, finding another investor whose available property fits one’s exact needs and who can close at the same time is very difficult—more a matter of serendipity than business strategy. Also, in a simultaneous exchange, an investor is dependent on the counterparty because any delay or change of heart on their part could cause the exchange to fail. With no time in which to arrange a new exchange, the investor would have to pay the full tax burden of the sale of the original property. This is why almost all 1031 exchanges come in other forms.

Two

Delayed Exchange

In the most common form of exchange, the “delayed exchange,” the seller relinquishes their property before buying the replacement property. The seller markets their property, finds a buyer, and closes the sale. The proceeds go directly to a third party (a Qualified Intermediary, discussed later) who holds the funds for up to 180 days. During the first 45 days of this period, the seller identifies one or more “like-kind” properties.

Three

Reverse Exchange

In a “reverse exchange,” an investor finds and parks a replacement property (through a Qualified Intermediary) before selling their own investment property. Reverse exchanges can present liquidity challenges because the replacement property must be purchased before the proceeds from the relinquished property are received, but the structure can be useful in certain circumstances.

Four

Construction Exchange

In a “construction exchange,” also known as an “improvement exchange,” an investor relinquishes their appreciated property and uses the tax-deferred profits to park and improve a replacement property. This option is difficult to execute because it requires an investor to purchase and complete improvements then acquire a property within 180 days, but it is tempting to real estate investors looking to buy and renovate a property.

These Are the Rules, So Be Careful, and Get Help

The 1031 exchange is a complex, multi-step procedure with pitfalls along the way for inexperienced property owners and investors. Here are some of the basic features shared by the exchange options just described.

Qualified Intermediary (QI)

Also called an Exchange Intermediary, a QI is the third party that holds the proceeds of the property sale, then disburses the funds to purchase the replacement property. Engaging an experienced and trustworthy QI is essential to success in a 1031 exchange because the QI ensures that the process is performed correctly and within the strict time frame.

“Like-Kind” Exchange

For the IRS, the phrase “like-kind” in this context means that 1031 exchanges can be used only for U.S. real estate and only for properties “held for use in trade or business or for investment.” This means that an investor cannot sell a personal residence or other personal property and use the funds to buy an investment property (or vice versa). However, as long as both properties involved are used for “trade or business or investment,” a wide range of properties can be exchanged (e.g., a farm for a hotel, a medical office for raw land). It is also important to note that a US taxpayer can sell their foreign property and exchange it for another foreign one. A vacation home might qualify if it is held for the purpose of rental to others. Domestic (USA) exchanged properties can be located in different states, but all USA properties must be replaced by real estate in the United States. More than two properties can be involved in the exchange, such as selling one property to purchase three replacement properties. Finally, the person buying the new property must be the same investor or taxpayer as the person selling the relinquished property. An exception to this rule occurs with single-member limited liability companies (or SMLLCs), wherein tax liability passes to the single member individual. The complexity of these rules is why hiring an experienced QI is so important.

Equal or Greater Value

The IRS requires that the replacement property (or properties) in a 1031 exchange be of equal or greater value to the relinquished property, in terms of net market worth and carried equity to defer all the tax. The logistical costs that accompany real estate transactions, such as broker and inspection fees, can be included in that total value figure. If an investor is unable to find a replacement property or properties of equal or greater value, they must pay capital gains taxes on the excess (known as the “boot”). For example, if a $1m property with $400k in capital gains is relinquished, and a replacement property is purchased for $980k (after all costs), the investor must pay capital gains on the $20k that went “unused” in the exchange (while still avoiding $380k in capital gains). This is perhaps a necessary option for those investors who struggle to find the right property or properties to swap because a suboptimal exchange might be far better than no deal at all.

Mortgage Debt

Investors should be aware that 1031 exchange requirements are based on the value of the property being sold, not the investor’s net equity. For example, if an investor sells a $500k property on which they owed $250k, the replacement property purchased must be valued at $500k (after all costs) or more, or the difference will be “boot,” as described earlier. This requirement further complicates the exchange because both the mortgage payoff on the existing property and the securing of a new mortgage for the replacement property must occur at the closing for the sale and the purchase.

Timeline

The 1031 exchange timeline must be followed closely because failing to do so can disqualify the entire exchange. To review, in a basic exchange, the first property is sold (“relinquished”), and the owner has 45 days in which to identify usually up to three like-kind replacement properties for purchase. After the 45 days have elapsed, the seller has an additional 135 days (for 180 total) to close on one or more of the replacement properties. Additional (often complicated) rules are also related to the timing of 1031 exchanges that investors must review with their QI, such as the 180-day limit possibly being shortened by the due date of the original owner’s tax return.

Other Options, Other Factors

The tax code allows for other exchange types that are too numerous and too narrow in focus to be explored here. For example, a 1033 exchange allows an exchange in the case of an “involuntary conversion,” such as when a property is destroyed by a disaster or is subject to an eminent domain proceeding. Again, enlisting a professional in the field is the smartest option because they can not only determine whether an exchange is an investor’s best option but also provide suggestions as to other possible options.

COVID-19 and the Current Moment

In response to the COVID-19 crisis, the IRS granted extensions to the 45-day and 180-day exchange deadlines. Investors should do their research and work with a real estate or tax professional to determine how rule changes due to the pandemic might affect a 1031 exchange or could benefit or complicate other aspects of their real estate investments. While these extensions have expired, if an exchange transaction is affected by a federally declared disaster, some extensions may be available to the investor.

1031 Exchanges: Risks and Potential

Overall, the use of 1031 exchanges has massive potential for real estate investors looking to defer taxes while they update their property portfolios, move into new areas of investment, accommodate lifestyle changes or simplify their real estate positions.

For all the potential these exchanges provide, they can often be confusing and complicated, with specific requirements of time and commitment on the part of the investor. Any investor interested in a 1031 exchange should therefore consult a QI before attempting to take advantage of the benefits these exchanges can offer. Hiring someone who knows what they are doing is key to reaching one’s investment goals.

1031 Exchanges: