What is a 1031 Exchange?

Everyone has heard the old adage that the only sure things in life are death and taxes. It’s a grim bit of gallows humor, but it holds some truth. And the IRS comes for more than just wages. For example, when real estate owners purchase a property and sell it for more than they purchased it for, the profits are known as capital gains.

Capital gains are considered income and subject to taxation.  While the seller cannot entirely avoid paying taxes on the profit, they can defer and delay payment of those taxes using a 1031 exchange. In fact, savvy real estate investors have been using 1031 exchanges to grow wealth for decades. 

How Does a 1031 Exchange Work?

Under U.S. tax law, property owners are allowed to defer the tax due on capital gains from the sale of a property if they use the profits to purchase a “like for like” property within 180 days of the original sale. If an owner does this, they have technically not profited from the sale, but rather “exchanged” 1 property for another. 

In doing so, they are able to defer their tax exposure from the original sale because the seller didn’t really make any profit. They simply traded 1 property for another similar one. The key here is “like for like,” which means the properties must be similar to each other. This similarity does not lie in property price, but property type. 

Other restrictions apply as well. Primary residences are not eligible for 1031 exchanges. The IRS automatically allows single tax filers a $250,000 tax credit — and $500,00 for married couples — on profits realized from the sale of a primary residence. That’s why the only properties eligible for 1031 title exchanges are income properties, business properties or investment properties. 

If you own a small automotive garage and decide to purchase a larger one, you can use the profits from the sale of the smaller garage to purchase a bigger garage without incurring any tax exposure. You could also do a 1031 exchange after selling a 4-unit apartment building and using the money to buy a nicer building in a more desirable area. However, you could not sell your auto garage and use a 1031 title exchange to buy a luxury yacht or even a new primary residence for yourself.

The law is written the way it is to encourage business owners and investors to keep recycling their money in the market as opposed to just dumping it in a savings account. 

You face no limit to the amount of 1031 exchanges you can do. As long as you conduct the exchange within the confines of the rules established by the tax code (and the time allotted for the exchange), you can roll profits over through 1031 exchanges indefinitely. That’s why savvy investors have been using 1031 title exchanges to grow their portfolios for decades. 

Advantages of a 1031 Exchange

The first and most obvious advantage of a 1031 title exchange is that it gives property owners more capital to buy another property. If you earn $500,000 in wages, you would be subject to the maximum federal tax rate of 37%, which would leave you with around $350,000 to make your new purchase. 

On the other hand, if you sold a property at a $500,000 profit, a 1031 title exchange would allow you to use some, or all, of your $500,000 profit to buy a similar property. That additional $150,000 gives you a lot of extra buying power. You can use as much or as little of your profit to make the exchange. Bear in mind however, that whatever portion of your profits you don’t use for the exchange will be subject to capital gains taxation. 

Drawbacks of a 1031 Exchange

A properly executed 1031 title exchange is a great way to build wealth or upgrade like-for-like investment properties. However, it’s not as easy as 1-2-3. First of all, if you’re exchanging a commercial property that is being financed, you need to take a look at your loan documents. 

Most commercial real estate loans have significant prepayment penalties. If you’re trying to exchange your financed property to buy another, these prepayment penalties could eat up a significant chunk of your profits. This situation could very well leave you without enough money to do the exchange. 

Secondly, there are time constraints. You have 45 days from the original sale to designate the property you’re buying to complete your exchange, and the entire exchange must be completed within 180 days. If your exchange doesn’t conform to these timelines, you’ll be fully responsible for the capital gains taxes due. That means you must be quick about finding an exchange partner. 

This timeline means exchanging vacation homes or rental properties can be especially difficult. The residential retail market is red hot, which means 1, or more, of the properties you’ve designated for the exchange could be sold at a higher price than you’re willing to offer. If that happens enough times in the 45-day exchange period, you could easily find yourself without a dance partner when the music stops. Then you’d be responsible for paying the taxes on your capital gains. 

Lastly, you will probably need a middleman to help you complete your exchange. One of the requirements of a 1031 title exchange is that the capital gains cannot be “realized” by the person doing the exchange. What that means in layman’s terms is that you can’t hold the money in your bank account, even while you’re waiting to close the new deal. Attorneys can hold the capital gains for you in a special escrow account, but of course, that costs money. 

1031 Exchange Tips

1031 title exchanges are a great way to move up the real estate food chain, but they require careful planning. You can’t just put your property on the market and assume that you’ll find a suitable exchange property after it sells. Remember, you’ve only got 45 days (6 weeks) to designate the property you’re going to use to complete the exchange. 

If you miss that deadline, the ballgame is over. That’s why it’s a good idea to have an exchange partner (or property) before you begin the process of making a 1031 title exchange. Otherwise, you could end up overbidding on properties you don’t like just to get in under the deadline. 

You will also need professional assistance in filing your taxes. An accounting professional will need to review your exchange and complete the proper forms before you can fully benefit from the tax advantages of a 1031 exchange. What’s more, your accountant, the attorney holding your exchange money and your real estate agent all need to be on the same page in order for your exchange to be successful. If you try to complete this process on your own, you could easily make a costly error. 

Although 1031 exchanges are a great way to build wealth or upgrade properties, you have to manage a lot of moving parts. If it all sounds like Greek to you, maybe it’s best to take a look at this list of Benzinga’s best real estate investment platforms and find a more passive way to earn money in real estate. 

Is a 1031 Exchange Right for You?

Every real estate investor is different, and money-making in real estate comes in many flavors. The effective use of 1031 exchanges is a well-established method of improving a portfolio and upgrading properties while minimizing tax exposure. However, risks accompany this approach, just as with other investments. If you plan properly and avail yourself of the assistance of savvy real estate professionals, the 1031 exchange can be an invaluable tool. But you need to understand the risks before proceeding. If you’d like to learn more about 1031 exchanges, or real estate investing in general, Benzinga is here as a resource for you. 

Frequently Asked Questions