What You Need to Know About 1031 Exchanges



If you invest in real estate, you’ll want to know about 1031 exchanges. They can save you a great deal at tax time if performed correctly when you sell a rental or other investment property. However, an incorrectly-executed 1031 exchange can become a costly nightmare. Here’s what you need to know to get it right.

What Is a 1031 Exchange?

A 1031 tax-deferred exchange allows you to avoid paying capital gains tax when you sell investment real estate as long as you use the proceeds of your sale to buy another investment property of equal or greater value within a specific period of time. This is called a “like kind exchange.” 

The 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code.

How Does a 1031 Exchange Save You Money?

It is almost always better to pay taxes later rather than sooner. Deferring tax on investment gains allows you to invest more. Suppose that you sell a rental unit and make a $100,000 profit. If you had to pay a 25% tax on the gain, you’ll have $75,000 to invest. Assuming that your next investment earns 5% per year, in five years you’ll have $96,252 ($71,189 after tax). 

If you are able to defer tax on your gain, however, in five years you’d have $128,336 ($96,252 after tax). In this example, the ability to defer taxes on your capital gains puts an extra $25,063 in your wallet. 

Paying tax later, when your taxable income is likely to be lower, can also save you money. If you’re currently in a 30% bracket and move to a 25% bracket after retirement, deferring your gains can save you even more. 

How to Do a 1031 Exchange

The 1031 exchange process requires some tricky timing. Here are the steps in chronological order:

  1. List your investment property for sale (called the “relinquished” property) and include the fact that you will be doing a 1031 exchange in the listing, so the buyer will have to comply with IRS requirements. That mostly involves signing paperwork and complying with deadlines. Understand that once you close on your sale, you have just 45 days to identify up to three replacement properties.
  2. Engage the services of a qualified intermediary. Unless you can get someone to directly exchange a replacement property for your relinquished property, you’ll need a qualified intermediary to facilitate your exchange. This person cannot be an immediate family member. While almost anyone not related to you can be a qualified intermediary, it’s best to engage a reputable service to administer your exchange for you.
  3. Negotiate with buyers and close on the sale of your relinquished property. The title company (or attorney in some states) administers the closing. The main difference between a 1031 exchange and a traditional real estate closing is that the proceeds don’t go into your personal bank account. Instead, your qualified intermediary will oversee the process, and the funds are transferred into the intermediary’s bank account.
  4. Identify up to three replacement properties. Your qualified intermediary takes care of the paperwork and makes sure that you meet all IRS deadlines.
  5. Make offers on your replacement properties. You will probably have a first choice property, but you can make contingent offers on the others. Once you have an accepted offer, you’ll open escrow on the replacement property.
  6. Close on the replacement property. You have 180 days from the time you close on your relinquished property to close on the purchase of the replacement property. Your qualified intermediary wires your money to the title company or attorney, and the purchase closes normally. 

You can repeat this process every time you sell investment property, deferring your taxes indefinitely. The additional compounding of your investment without taking out taxes can seriously increase your wealth over time.

Reverse 1031 Exchange

While the traditional 1031 exchange involves selling property and then buying a replacement property, that’s not the only way to defer capital gain taxes. You can perform the 1031 exchange in reverse by purchasing the replacement property and then selling your relinquished property. 

In that case, you buy your replacement property, using the services of a qualified intermediary. The intermediary takes title and possession of your replacement property and holds it until you close on the sale of your relinquished property. 

You have 180 days to close the sale of the relinquished property. Note that your intermediary is listed as the seller. The reverse 1031 exchange may allow you to jump on a great investment deal and then sell another property to take advantage of the tax law. However, if the sale of the relinquished property fails to close on time, you’re on the hook for the taxes on your gain. And you’ll have paid for the services of the intermediary without getting the tax benefits of the exchange. 

Finding a Qualified Intermediary

Technically, almost anyone can function as a qualified intermediary. But it’s risky to use someone who may not know what they’re doing because one mistake with timing or paperwork could cost you thousands or even hundreds of thousands of dollars. Escrow companies, attorneys, real estate agents, etc. are agents and should not be used as facilitators.

The Federation of Exchange Accommodators (FEA) has a qualified intermediary certification program and maintains a directory of Certified Exchange Specialists. Certified members must have at least three years of full-time experience at a qualified intermediary company and complete at least 20 hours of continuing education every two years.

Choose a 1031 exchange company that has been in business for a number of years and has a good reputation. The firm should be large enough that someone will be available to complete your process on time even if your representative can’t perform due to medical or family emergencies. 

Finally, ask about their errors and omissions (E and O) insurance and make sure the firm is covered. The industry is not highly regulated, and you want to make sure the intermediary can compensate you if someone makes a costly mistake. 

FAQs

What Kind of Property Qualifies for a 1031 Exchange?

Any property held for productive use in a business or for real estate investment can be exchanged for like-kind property. You can exchange a single-family residence for a duplex, raw land, an apartment building or even a retail shop. However, if you’re in the business of rapidly buying and selling or flipping properties, the IRS considers you a “dealer” and your properties “inventory.” In that case, you won’t be allowed to do a 1031 exchange. You can even exchange out of one property and into multiple properties.

How Much Does it Cost to Do a 1031 Exchange?

Fees for a 1031 exchange typically run between $400 and $1,000 depending on the service used for a basic 1031 exchange. If you opt to have your attorney review the documents, that will increase your cost (but potentially reduce your risk). Reverse exchanges and other more complex transactions like build-to-suit exchanges can cost much more with fees running into several thousand dollars. Your costs are a factor when calculating your return on investment. For smaller transactions, it may not make sense to incur the cost of a 1031 exchange. 

Can I Use the Exchange Proceeds to Cover Closing Costs?

The IRS stipulates that in order for closing costs to be paid out of exchange funds, the costs must be considered a “Normal Transactional Cost.” Examples of Normal Transactional Costs include sales commissions, legal fees, escrow fees, inspection costs, transfer taxes, title insurance, property taxes and exchange fees. Examples of costs not allowed include mortgage lender fees, utilities, repairs, homeowner dues and property liability insurance. 

What Is “Boot?”

To fully take advantage of a 1031 exchange, you must use all the proceeds from the sale of the relinquished property to purchase replacement property. If you take some of the proceeds for other purposes, that portion is considered a taxable gain, aka “boot.” If you gain $120,000 but only invest $100,000 in the replacement property, you’ll end up with $20,000 in taxable boot. 

Mistakes by you or your intermediary can cause you to end up with accidental boot. This can happen if funds in the exchange account get used for disallowed transaction costs such as repairs or mortgage lender fees. Make sure those fees come from another source if you don’t want an unexpected tax bill. 

Your mortgage can also create unintended boot. Suppose that your mortgage balance on the relinquished property was $120,000, but the new mortgage balance for the replacement property is only $100,000. You have $20,000 of taxable boot even if you use the entire sales proceeds to buy the replacement property. Or suppose that you put all of your proceeds into a replacement property but then you borrow too much and end up with a refund after closing. That extra cash is taxable.

Finally, property sales often include personal property such as furniture or appliances that cannot be counted as “like kind” exchanges. The value of those items may become taxable boot unless you structure your purchase contract to state that included items are “conveyed at zero value.” 

1031 exchanges can help you retain and create wealth over time when you invest in real estate. Just make sure you hire a competent, experienced facilitator for your transaction and keep an eye on your deadlines. 

Thomas O'Shaughnessy About Thomas O'Shaughnessy