Should You Do A 1031 Exchange?

You may have heard the term ‘1031 Exchange’ before in the realm of real estate. 1031 exchanges are a tool you can use as a real estate investor to achieve a variety of goals related to your rental business or investment property portfolio. 

In this article, we’ll first review the basic concept of 1031 exchanges and then provide a balanced look at some of the advantages and risks savvy real estate investors should be aware of regarding the strategy. 

What are 1031 Exchanges? 

Also known as like-kind exchanges, 1031 exchanges get their name from Section 1031 of the Internal Revenue Code, or IRC. 

This term refers to a real estate strategy or tool that allows investors to switch out one investment property (the relinquished property) for another (the replacement property), without paying capital gains tax on the sale.  

Typically, the federal government implements capital gains taxes between 15% to 20% on real property sales proceeds. In a 1031 exchange, you can sell your property and apply the proceeds to another property without paying tax on those proceeds. There’s no limit to the number of 1031 exchanges you can conduct, so you could theoretically apply the gain on one investment property to the next, rolling over capital gains until the very last property you sell, at which time you’ll pay tax once on your long-term capital gains. 

Which Properties Can Be Exchanged? 

The main condition of a 1031 exchange is that the old and new investment properties must be “like kind.” This means that potential replacement properties must be similar in function and general nature (e.g., a property used for long-term investment must be exchanged for another long-term investment property, not a vacation home or personal residence). Additionally, a qualified intermediary (QI) must facilitate the exchange and hold your capital gains in an escrow account during the transaction, which you cannot access except to purchase the replacement property. 

For more detailed information about 1031 exchanges and what qualifies, see this IRS fact sheet. 

Why Do A 1031 Exchange? 

You already know about avoiding tax with 1031 exchanges. But are there other reasons to use this strategy? 

You might choose to pursue a 1031 exchange to invest in a rental property with higher return on your investment, or ROI. 1031 exchanges also reset your depreciation schedule, which is the length of time over which you must take deductions to account for the general wear and tear of the property over time. If you’ve already depreciated your apartment building for 20 years, for example, conducting a like-kind exchange will reset that count to zero.  

Lastly, some investors also use 1031 exchanges to consolidate multiple properties into one or sell one property to invest in multiple new ones or in vacant land for building. 1031 exchanges leave room for investors to be creative and/or strategize the use and performance of their entire rental portfolio.   

Advantages of 1031 Exchanges 

There are many 1031 exchange benefits. Here are some of the most salient benefits for investors: 

• Avoid/defer capital gains tax during a sale. It’s the primary benefit of 1031 exchanges and the main reason investors choose to conduct them. Keep in mind that it’s technically only a delay of taxes, but in theory, investors can keep using multiple exchanges to postpone taxes indefinitely while continuing to identify potential replacement properties of equal or greater value.  
• Allow a third party to handle the sale of your property. A qualified intermediary facilitates the majority of the exchange, and their responsibilities range from preparing asset documentation and communicating with the title company to handling funds and filing and keeping detailed records.  
• Increase equity. Equity is one of the biggest 1031 exchange benefits. 1031 exchanges are a prime way to continue increasing equity on the property you own and your portfolio as a whole. 
• Grow or diversify your portfolio. Most landlords who utilize 1031 exchanges can use this tool to successfully grow or reinvent their real estate portfolios to suit their property interests. You can exchange real property to invest in a new kind of real estate or a new market and reap the future benefits of its profits. 

Risks of 1031 Exchanges 

As is true for any strategy, there are also some downsides involved in 1031 exchanges. Below are some of the risks of conducting a 1031 exchange: 

• More complex tax documentation. In order to conduct a 1031 exchange, you’ll need to file IRS Form 8824 with your tax return. This form requires you to lay out all the details of the exchange, including the properties involved, a timeline of the exchange, the qualified intermediary’s name and information, and the details of the actual financial transaction. 
• Adherence to standards and regulations. These exchanges tend to be more scrutinized by the IRS, and subsequently, they must follow more rules and regulations. You could be penalized for breaking any of these rules or forgoing any procedures. 
• Responsibility to choose an experienced qualified intermediary. You will need to invest in some research up front to choose the best facilitator for your exchange.  
• Strict timelines may apply. 1031 exchanges are strictly regulated by the IRS. For instance, investors only have 45 days after selling the relinquished property to find a replacement property and only 180 days to close on that property in a delayed exchange. 
• Some taxes may still apply. For instance, if your mortgage on the new property is lower than the old one, you may be taxed on the difference between the two mortgages. You’ll also get taxed on the property sale if the exchange is unsuccessful or if you conduct more than one 1031 exchange over time.  

Does 1031 Exchange Avoid State Taxes? 

In most states, you can defer capital gains taxes on the state level in the same way you avoid federal taxes when you make a 1031 exchange. However, there are a few stipulations that apply, and not all states provide for the tax deferral, including California and Massachusetts. If you do a 1031 exchange in a deferral state but later sell it in a taxable one, one or both states may collect taxes on the sale. In other states, there are mandatory tax withholding rules for nonresidents that may impact a 1031 exchange. It’s important to be informed on your state’s laws and regulations before beginning the 1031 exchange process.  

Conclusion 

For many investors, 1031 exchanges can be a beneficial strategy to defer taxes and reinvest in their portfolio. However, the best way to attempt one is with the guidance of an experienced qualified intermediary and a strong understanding of the 1031 exchange process and related IRS regulations.