What Is a 1031 Exchange? Minimizing the Tax Bill On Your Real Estate Investment

Real estate has long been a favorite amongst investors. It provides consistent passive income in the form of rent, and it appreciates in value, so you can also generate hefty profits by selling the property. 

If you do decide to sell your rental property though, you could get hit with a huge tax bill on the capital gains (anywhere from 15% to 20%). You might even have to pay state capital gains taxes depending on where you live. 

Another tax liability real estate sellers often forget to account for is depreciation. Depreciation is the wear and tear to your real estate, which you can write off of your taxes every year as a cost.  As far as the IRS is concerned, your property value = Purchase price + Capital gains - Depreciation. 

If your property sells for more than its depreciated value, then the IRS will recapture (e.g. charge you for) the depreciation at a 25% rate. All of this to say, there are many reasons you’d want to minimize your taxes from a property sale. 

That’s where the 1031 exchange comes in.

According to Section 1031 of the U.S. Internal Revenue Code, investors can defer capital gains taxes by trading one investment property for another of similar kind. In other words, a 1031 exchange allows you to keep most (if not all) of the gains you made from your rental property sale and reinvest them. 

But the key word here is defer. Once you sell off your investment properties for cash, you will have to pay the capital gains taxes you owe up to that point. But stick around until the end, and I’ll show you a clever way to eliminate those pesky taxes for good. 

So, 1031 exchanges sound great, right? Not so fast. The IRS isn’t just going to let you keep all that money without a fight, so they structured 1031 exchanges around a bunch of rules and procedures.

Quick disclaimer: there are several types of 1031 exchanges, including delayed exchanges, built-to-suit exchanges and reverse exchanges. Each exchange, in turn, comes with its own set of requirements. So for the sake of brevity, I’ll be outlining the delayed exchange, which is the most common type of the 1031 exchange. 

The delayed 1031 exchange consists of 4 main steps: 

1. Complete the sale of your Relinquished Property.
2. Send the proceeds to a Qualified Intermediary.
3. Identify a Replacement Property to buy within 45 days.
4. Have the qualified intermediary transfer the money and finalize the purchase within 180 days.

Most real estate transactions involve middlemen, and 1031 exchanges aren’t any different. Since the proceeds from your Relinquished Property sale are still taxable, you’re required to transfer the money to a Qualified Intermediary (QI). This middleman will safeguard it for you, and transfer it to the seller once you’re ready to pull the trigger on the Replacement Property.

First things first: to even qualify for a 1031 exchange, both properties have to be located in the US. So you can’t, for example, trade one U.S. property for a Puerto Rican property under a 1031 exchange. The IRS isn’t going to let that fly.

When it comes to choosing a Replacement Property you have to keep 3 rules in mind: the deadlines, the property type and the number of properties you can buy. Let’s break it all down.

Deadlines

There are two deadlines in a 1031 exchange, both of which start counting the second you finalize the sale of your Relinquished Property. These deadlines are:

1. You have to designate the Replacement Property in writing to the QI within 45 days.
2. You have to close on the Replacement Property within 180 days.

Property type

The Replacement Property has to be of “like-kind” to your Relinquished Property. Fortunately, the definition of “like-kind” is pretty broad. It doesn’t have anything to do with the appearance or exact characteristics of the property. You could, for instance, even choose to exchange an office building for farmland. 

You can choose pretty much any property as long as it is:

• An investment property, not a personal residence
• Approximately equal to or greater than the value of your Relinquished Property

Identification limits

There are also a few rules that limit how many new properties you can identify and ultimately buy:

• 3 Property Rule: You can identify and buy up to 3 properties, no matter their market value.
• 200% Rule: You can identify more than 3 properties, as long as their total value is no greater than 200% of your Relinquished Property’s value. 
• 95% Rule: You can identify more than 3 properties whose total value exceeds 200% of your Relinquished Property’s value, so long as you buy at least 95% of the properties you identify. 

That last rule is pretty hard to comply with, which is why most investors don’t bother with it.

A 1031 exchange is a great way to defer capital gains taxes, but only if you’re able to follow all the IRS’ rules and requirements to a T. Let’s weigh the pros and cons, so you can determine whether a 1031 exchange makes sense for you.

As an investor, some of the reasons why you may want to take advantage of a 1031 exchange include:

Tax deferral

When you sell one property and pay capital gains taxes, only to buy another property right after, then you’ve just lowered your purchasing power. By utilizing a 1031 exchange, you roll your gains over into the next property so you can build a more valuable real estate portfolio faster. 

Favorable tax rate

There’s no limit on how many times you can do a 1031 exchange. And when you finally do decide to cash out, you’re taxed at a long-term capital gains rate. The rate is capped at 20%, but it could also be lower depending on your income. Most people don't pay more than 15%.

Zero taxes owed

Another huge benefit of 1031 exchanges is that you can take those capital gains with you to the grave. Upon your death, all deferred taxes are erased and your heirs will simply inherit your property at market value. How’s that for generational wealth?

The obvious disadvantage here is that you won’t get any cash in the bank. But maybe that’s not such a bad thing, considering the rising inflation rates. In either case, here are a few more downsides.  

Strict rules

1031 exchanges have a bunch of rules that might have you racing against the clock to comply with. And failing to follow any of them could result in the IRS disqualifying your swap and putting you on the hook for capital gains taxes anyway. That’s why it pays to plan ahead and have backup properties in case your first pick doesn’t pan out. 

Extra costs

Real estate transaction costs are already sky high. To top it all off, you’ll need to hire a Qualified Intermediary (QI) to facilitate your 1031 exchange—which can cost up to $1,250. 

Unexpected taxes

Any money that’s leftover at the end of a 1031 exchange is referred to as “cash boot”. Who doesn’t like saving money, right? Well, the only problem is that the cash boot is taxable. And even though it sounds like it only applies to cash, the boot also applies to loans.

So, if your mortgage on the Replacement Property (e.g. $700K) is lower than the mortgage on your Relinquished Property (e.g. $800K), then the $100K difference is taxable.

When used properly, a 1031 exchange can be an effective tax deferral strategy that can help you build wealth. But 1031 exchanges aren't right for everyone. You want to make sure the investment property you plan to purchase qualifies in the first place. A 1031 exchange requires a 2-year holding time at minimum, so it’s not a good choice if you might need to sell your investment for cash anytime soon.

Also, do the math on your taxes to make sure you'll benefit from using this trick. If you don't incur any capital gains on the sale of your property after deducting losses, it doesn't make sense to use this rule because you don't have any gains to be taxed. If you're currently in a low tax bracket and expect to move up in the future, it might make more sense to bite the bullet and pay your capital gains taxes now rather than defer them. If your income is low enough, you might not even be liable for capital gains taxes at all. However, high net worth individuals can often benefit from deferring capital gains taxes using a 1031 exchange.