1031 Exchange: The Basics, Rules and What to Know

Our firm has been involved in numerous 1031 exchanges, and although they can be complicated, knowing the right information can lead to big benefits for investors. Here is all you need to know about a 1031 exchange.

What is a 1031 exchange and how does it work?

A 1031 exchange (also called a like-kind exchange or a “Starker”) occurs when an asset is sold, and the money gained from the sale is used to purchase a like-kind asset of equal or greater value to defer paying capital gains taxes.

When will I pay taxes on my 1031 exchanged assets?

The taxes will come due once you sell your property without exchanging it. At this point, you will have a tax event. If you’ve held the property for longer than one year, you will pay long-term capital gains taxes. Long-term capital gains taxes can be anywhere from 0%-20% depending on your income. [1]

What are the rules of a 1031 exchange?

The properties exchanged must be like-kind properties in the eyes of the IRS.
- For example, you cannot sell a $1 million yacht and exchange it for a $1 million apartment building to defer paying taxes on the capital gains from the yacht.
The property needs to be of equal or greater value.
- If you exchange for a property of lesser value, you will be subject to taxes on the funds that you did not use towards the new property.
Both properties have to be held in the same name
- For example, you cannot have the relinquished property in ABC Investments LLC, and the new property in XYZ Investments LLC.
You must identify the property you are exchanging within 45 days.
You must use a qualified intermediary.
- This is a third-party escrow account that holds the profits from the sale of the asset. Intermediaries also help facilitate the exchange, ensuring IRS compliance.
You must close on the exchanged property within 180-calendar-days.
- Failure to close on time can disqualify you from the 1031 exchange, and you will be responsible for the capital gains taxes from the sale of the original property.

What counts as Like-Kind Properties?

All real property is generally considered like-kind property, whether it is improved or unimproved. For example, you can exchange an apartment building for an office building or raw land for a warehouse building. Real property outside of the United States is not considered like-kind property.

What does not count as Like-Kind property?

Personal or intangible property does not count as like-kind property. For example machinery, equipment, vehicles, artwork, collectibles, patents generally do not qualify, with very few exceptions. [2]

Why is it called a 1031 Exchange?

The name comes from Section 1031 of the U.S. Internal Revenue Code.

What is the history behind the 1031 Exchange?

The Section 1031 code was first introduced in 1921 by the U.S. Congress.

It is also known as “Starker” from the infamous Starker Family case. Taxpayer T.J. Starker attempted to sell his timber property and swap it for a like-kind asset within 5 years. The IRS denied Starker the ability to defer his taxes by using 1031 Exchange. However, the Ninth Circuit Court ruled in favor of Starker and against the IRS, stating that the tax code did not support the swap needing to be simultaneous.

Soon after this, Congress adopted the 45-calendar-day identification deadline and the 180-calendar-day exchange period that we see today.

Can I decide to do a 1031 Exchange if I have already sold the property?

No. The proceeds from the sale of the relinquished property must be placed with a qualified intermediary to hold the funds and ensure compliance during the 1031 exchange process. You must also apply with the appropriate IRS 8824 form. If you touch the proceeds from your relinquished property, you are no longer eligible to do a 1031 exchange.

What is a Delaware Statutory Trust Fund (REIT)

A Delaware Statutory Trust Fund (DST) is a legally recognized trust where the property is invested, managed, and held. DST’s are commonly utilized when investors need to do a 1031 exchange but are not able to identify a deal that matches their goals within 45 days.

How long do you have to hold property in a 1031 exchange?

There is no set time that you have to hold property after you purchase it during a 1031 exchange. The only requirement is that you purchase the property with the intent to hold it as a business investment.

What happens if I can’t complete my 1031 exchange?

There is no penalty from the IRS for not completing the 1031 exchange. However, you will be responsible for the capital gains tax for the sale of the original property and possibly fees associated with the attempt to purchase the new property.

Is there a cap on the dollar amount investment that I can do a 1031 exchange on?

There is no limit on the amount, the number of times, or how frequently you can exchange properties.

What kind of property qualifies for a 1031 exchange?

1031 exchanges are reserved for property held for productive use in a trade or business or investment. This excludes primary residences and “flippers”.

Is there any other way to defer capital gains taxes other than through a 1031 Exchange?

There are several other ways to avoid capital gains taxes:

Invest using a self-directed IRA or a Roth IRA.
1. You can invest using a self-directed IRA or Roth IRA and postpone paying the taxes until you turn 59 ½ years old. The IRS has very strict guidelines for this method, so be sure to check with your tax advisor if utilizing this method.
Move into the property for 2 years.
1. As long as you have lived in the property for at least 2 of the last 5 years, you can avoid capital gains tax up to $250,000 for single filers and up to $500,000 for joint filers. Read more about this at IRS.gov.
Keep good records.
1. By keeping a record of your capital investments on your property, you can use this to up the cost basis for your property.
  1. For example, if your property costs $500,000, and you sold it for $550,000. Normally, you would have $50,000 subject to capital gains tax. However, if you’ve spent $30,000 on a new roof, interior upgrades, and a new HVAC system. You are now only liable for $20,000 of capital gains tax.
Reduce your taxable income.
1. Invest more into your retirement accounts.
2. Itemize your tax deductions.
3. Contribute more to a health savings account. Read more about this on IRS.gov
Sell off negative income-producing assets
1. Selling off negative income-producing assets can help you to offset capital gains taxes. For example, if you lose $10,000 on a stock, and sell it during the same year of your capital gains. Your capital gains of $20,000 will be offset by your $10,000 stock. Now, you would only be subject to $10,000 in capital gains tax.
Gift the property to a family member.
1. By gifting the property to a family member, you can avoid paying the capital gains tax. However, if they decide to sell the property before you die, they may be subject to your capital gains tax. Read more about this at IRS.gov
Donate the property to a charitable organization.
1. You will avoid paying capital gains taxes, and you may also be able to take a deduction from your normal income.

What are the disadvantages of 1031 Exchanges?

There is a tight deadline.
1. If you miss the deadline there is no extension option.
You are likely to pay higher premiums.
1. Your representative knows that you have to make a purchase and often is less incentivized to get you the very best deal for your money.
It can be very difficult to find Like-Kind Properties of equal or greater value.
1. Planning is crucial to a successful 1031 exchange to make sure you can identify a property that matches your goals.
You may be taxed on “Boot”.
1. If you purchase a property for less than the amount of your relinquished property, you will have a tax event to pay taxes for the funds that you gained from the relinquished property and did not put towards the new property.
2. If you take money out of the qualified intermediary’s capital before closing, this money will be subject to capital gains tax. Read more about what the QI money can be used for during the transaction here from the American Bar Association.

Do I have to use all of the funds from my 1031 Exchange?

No, but the amount that you keep will be subject to capital gains tax.

3 Most Common Mistakes

Breaking the Timeline.
1. The 180-calendar-day countdown begins at the sale of the relinquished property.
2. A common mistake is to assume that the 180 days start once you identify a property.
Choosing the wrong custodian.
1. This is the number one source of real estate capital theft.
2. Make sure your custodian is bonded and insured.
3. It is a very low bar to become a custodian and the industry is not well-regulated.
Misunderstanding the rules.
1. The money that the qualified intermediary holds can only be used tax-free during closing. You can withdraw money from the intermediary, but it will be subject to capital gains tax. Read more about what you can use the intermediary funds here from the American Bar Association
2. If you only own a portion of the original property, you can’t sell only your shares and do a 1031 exchange with your shares into a new property. It must be the same company name that holds the relinquished property purchasing the new property.

Is there a limit on the number of times you can do 1031 exchanges?

There is no limit to the number of times you can exchange or how frequently you may exchange property.

However, if you attempt to exchange quickly after a property is acquired, or if you trade several properties throughout a year, the IRS may consider you a “dealer”. In this case, the properties may be considered stock in trade by the IRS. People with stock in trade are not allowed to exchange unless they can prove that it was held strictly for investment purposes.

The IRS does not set clear guidelines for what constitutes a “dealer”. There is no set time frame for how long the property is to be held and no structure for proving the motivation for the purchase of the asset. Because of the grey area surrounding this, it is not a common issue for real estate investors.

What are the four different types of 1031 Exchange Structures?

Delayed Exchange
1. This is the most common type of 1031 Exchange. This option gives the taxpayer 3 options.
  1. Option 1 allows an exchanger to identify up to three replacement properties, with no restrictions on price.
  2. The second option allows for the consideration of an unlimited number of replacement properties, with a limit of 200% of the price of the property sold.
  3. Lastly, the third allows the taxpayer to specify an unlimited number of properties but requires that they obtain a number that sums up to at least 95% of their entire market price.
Reverse Exchange
1. This can be utilized when the seller identifies a property to purchase before selling their relinquished property.
2. This type of exchange is still subject to the 45-calendar-day identification and 180-calendar-day close
Simultaneous Exchange
1. This occurs when the relinquished property is sold, and the purchase of the new asset happens on the same day.
2. A qualified intermediary is still required in a simultaneous exchange.
Improvement Exchange
1. This type of exchange is far less common than delayed or reverse exchange. It is used when the investor needs to improve the asset before taking possession.
2. The work must be completed before the 180-calendar-day close of the replacement property.

Are you searching for a multifamily property for a 1031 exchange?

You can view our listings here. Additionally, we can also help you with all aspects regarding multifamily brokerage. From asset valuation and coordination of the marketing process, to contract negotiations and more, we help clients open doors and close deals. You can contact us here if you have