1031 Exchanges Explained

Today we are going to be talking about what a 1031 exchange is in real estate and how it can save your clients a lot of money in the future.

So what is a 1031 exchange? The bill gets its name from IRC section 1031 and basically, it’s when someone swaps one business or real estate investment property for another to defer paying their capital gains taxes for gains made on the original property. You can do a 1031 exchange as much as you want, so someone could theoretically use these to defer their capital gains taxes from their investment properties for as long as they like. There are a few key caveats to this though that we are going to be talking about.

Like-Kind Properties

The main caveat behind a 1031 exchange is that the properties in question must be of a like-kind. This isn’t actually as restrictive as it sounds though. Almost any real estate property will be considered like-kind by the IRS, so this means that someone can trade something like a single-family residence for something much bigger like an apartment complex, or even something like farmland.

The main factor though is that both properties must be located in the United States. You cannot exchange one property from Canada for another one in the United States for example.

The other rule is that both properties involved in the exchange must be for investment use primarily. Someone could not exchange an investment property for a personal use one. They can still use one of the investment properties for vacation use though as long as it is extremely limited, and they have good bookkeeping to prove the investment nature of the property. Just like how they can use an investment property for vacation use, they can also turn a vacation house into an investment as long as they rent it out primarily.

Important Rules

The main rule in a 1031 exchange is that someone could not use any of the tax money they are trying to have deferred for personal purchases. The IRS states that if they receive any kind of monetary benefit from the exchange of the two properties then they will not qualify for a 1031 exchange. This means that the property they are buying must be equal to or more expensive than the property they are selling. They can, however, use the money that they make from actively holding onto the property they purchased, so this means that if they have someone actively renting out their property then they can use the rental income they receive for personal purchases.

Another key rule to the exchange is that they need to have a replacement property identified within 45 days of the sale. This means that within 45 days of selling their property they must have a written letter or form which is signed and dated by them and contains a detailed description of the replacement property they're looking at. The property doesn’t need to be under contract by the time they identify it, but that will leave them with a lot of risk. They can also choose to change the property they have identified at any time within the 45-day period they have from selling their last property. Once they have identified the property they plan to purchase they must have the paperwork delivered or postmarked to the qualified intermediary who is looking over the process of their exchange.

So they have 45 days to identify the property, but they can’t just wait indefinitely after the property has been identified. After selling the old property they will have 180 days to purchase it or else their 1031 exemption is void and they will owe capital gains taxes on the sale. In the case that the purchase of their replacement property won’t be completed by the time they owe their taxes then they can request an extension on their taxes from the IRS. It’s also important to know that the 45 and 180-day periods run at the same time and not separately.

When it comes time to report the exchange to the IRS, they have to fill out form 8824 and submit it with their tax return. The form asks about descriptions of the properties they exchanged, the dates when the exchange happened, any possible relationships with other parties involved, and the value of the properties involved in the trade.

Risks

Now just because someone can do this doesn’t mean it’s always the best idea, and there are a lot of risks involved in doing a 1031 exchange. The primary one is that you still need to pay your capital gains taxes from the previous properties once you stop making exchanges and sell your property. This means that you may end up with a very large tax bill that you may not have the money to pay.

You also need to be very careful with how the exchange is being filed with the IRS. If the IRS doesn’t accept the exchange due to any number of reasons, then you could end up with a tax bill that you don’t have the cash for.

Another big risk with an exchange is that just like how capital gains get deferred, your losses do also, so anyone planning on using a loss from one property to offset the gain from another needs to know that they cannot then use a 1031 exchange.

The Biden administration has also come out against 1031 exchanges and has spoken about the idea of either ending or limiting 1031 exchanges to $500,000 or $1 million depending on your marital status.

Conclusion

A 1031 exchange is a great idea for investors as long as they know about the possible risks in advance. If the exchange is done correctly and hopefully with the help of a qualified intermediary, then it could be an amazing way to temporarily save money on their taxes. The extra benefit of being able to do multiple exchanges while still deferring their taxes is also super beneficial for investors looking to grow their portfolios as fast as possible. Like I said earlier though, they can also use the money they generate from tenants at their properties for personal use so they can grow their income before having to pay the capital gains taxes they would normally owe.

Plus with inflation at all-time highs, the real value of their tax bill is going to decrease over time as inflation continues.