What is a 1031 Exchange?

A 1031 Exchange is a powerful tax-deferral strategy that allows real estate investors to sell an investment property and reinvest the proceeds into another like-kind property—without paying capital gains taxes at the time of sale. Named after Section 1031 of the Internal Revenue Code, this strategy helps investors grow wealth by deferring taxes and using the full value of their investment to acquire more or better real estate.

While the rules are strict and timelines tight, a properly executed 1031 Exchange can be a game-changer for building long-term real estate wealth.

How Does a 1031 Exchange Work?

Under U.S. tax law, property owners are allowed to defer the tax due on capital gains from the sale of a property if they use the profits to purchase a “like for like” property within 180 days of the original sale. If an owner does this, they have technically not profited from the sale, but rather “exchanged” one property for another.

In doing so, they are able to defer their tax exposure from the original sale because the seller didn’t really make any profit. They simply traded a property for another similar one. The key here is “like for like,” which means the properties must be similar to each other. This similarity does not lie in property price, but in property type.

Other restrictions apply as well. Primary residences are not eligible for 1031 exchanges. The IRS automatically allows single tax filers a $250,000 tax credit — and $500,00 for married couples — on profits realized from the sale of a primary residence. That’s why the only properties eligible for 1031 title exchanges are income properties, business properties, or investment properties.

If you own a small automotive garage and decide to purchase a larger one, you can use the profits from the sale of the smaller garage to purchase a bigger garage without incurring any tax exposure. You could also do a 1031 exchange after selling a 4-unit apartment building and using the money to buy a nicer building in a more desirable area. However, you could not sell your auto garage and use a 1031 title exchange to buy a luxury yacht or even a new primary residence for yourself.

The law is written the way it is to encourage business owners and investors to keep recycling their money in the market as opposed to just dumping it in a savings account.

You face no limit to the amount of 1031 exchanges you can do. As long as you conduct the exchange within the confines of the rules established by the tax code (and the time allotted for the exchange), you can roll profits over through 1031 exchanges indefinitely. That’s why savvy investors have been using 1031 title exchanges to grow their portfolios for decades.

Advantages of a 1031 Exchange

There are several key advantages to utilizing a 1031 exchange for investors, such as:

• Deferment of Capital Gains Taxes: One major benefit is the ability to defer the payment of capital gains taxes, which can result in substantial savings and increased cash flow for the investor. By reinvesting the full amount of the proceeds into a new property, the investor can defer taxes on both the initial investment and any appreciation in value, allowing for the continued growth of their real estate portfolio.
• Flexibility and Diversification: Additionally, a 1031 exchange provides investors with greater flexibility and potential for diversification. Instead of being limited by the tax implications of selling a property, investors can strategically reallocate their funds into different types of properties or markets to better align with their investment goals. This can help enhance the overall performance and stability of their real estate holdings.
• More Capital: A 1031 title exchange gives property owners more capital to buy another property. If you earn $500,000 in wages, you would be subject to the maximum federal tax rate of 37%, which would leave you with around $350,000 to make your new purchase. On the other hand, if you sold a property at a $500,000 profit, a 1031 title exchange would allow you to use some, or all, of your $500,000 profit to buy a similar property. That additional $150,000 gives you a lot of extra buying power.

Drawbacks of a 1031 Exchange

A properly executed 1031 title exchange is a great way to build wealth or upgrade like-for-like investment properties. However, it’s not as easy as 1-2-3. There are some drawbacks to this strategy.

• Prepayment Penalties: First of all, if you’re exchanging a commercial property that is being financed, you need to take a look at your loan documents. Most commercial real estate loans have significant prepayment penalties. If you’re trying to exchange your financed property to buy another, these prepayment penalties could eat up a significant chunk of your profits. This situation could very well leave you without enough money to do the exchange.
• Time Constraints: You have 45 days from the original sale to designate the property you’re buying to complete your exchange, and the entire exchange must be completed within 180 days. If your exchange doesn’t conform to these timelines, you’ll be fully responsible for the capital gains taxes due. That means you must be quick about finding an exchange partner.
• Need for a Middleman: One of the requirements of a 1031 title exchange is that the capital gains cannot be “realized” by the person doing the exchange. What that means in layman’s terms is that you can’t hold the money in your bank account, even while you’re waiting to close the new deal. Attorneys can hold the capital gains for you in a special escrow account, but of course, that costs money.

1031 Exchange Tips

1031 title exchanges are a great way to move up the real estate ladder, but they require careful planning. You can’t just put your property on the market and assume that you’ll find a suitable exchange property after it sells. Remember, you’ve only got 45 days (6 weeks) to designate the property you’re going to use to complete the exchange.

If you miss that deadline, the ballgame is over. That’s why it’s a good idea to have an exchange partner (or property) before you begin the process of making a 1031 title exchange. Otherwise, you could end up overbidding on properties you don’t like just to get in under the deadline.

You will also need professional assistance in filing your taxes. An accounting professional will need to review your exchange and complete the proper forms before you can fully benefit from the tax advantages of a 1031 exchange. What’s more, your accountant, the attorney holding your exchange money, and your real estate agent all need to be on the same page in order for your exchange to be successful. If you try to complete this process on your own, you could easily make a costly error.

Although 1031 exchanges are a great way to build wealth or upgrade properties, you have to manage a lot of moving parts. If it all sounds like Greek to you, maybe it’s best to take a look at this list of Benzinga’s best real estate investment platforms and find a more passive way to earn money in real estate.

Is a 1031 Exchange Right for You?

Every real estate investor is different, and money-making in real estate comes in many flavors. The effective use of 1031 exchanges is a well-established method of improving a portfolio and upgrading properties while minimizing tax exposure. However, risks accompany this approach, just as with other investments.

If you plan properly and avail yourself of the assistance of savvy real estate professionals, the 1031 exchange can be an invaluable tool. But you need to understand the risks before proceeding. If you’d like to learn more about 1031 exchanges or real estate investing in general, Benzinga is the right resource for you.

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