1031 Exchanges Explained: What This Tax Strategy Means for Investors

The goal of 1031 exchange for investors is simple: tax deferral.

What is difficult for the solo investor: completing all Section 1031 of the U.S. Tax Code requirements without the advice of necessary professionals.

These qualifications are key to making sure that your 1031 exchange investment transactions avoid an instant tax bill.

Although many investment properties can meet the qualifications for an eligible property in a 1031 exchange, you can face real tax consequences if you do not plan the investment transactions correctly.

Learn more below about how the average real estate investor can enjoy the tax-deferral benefits of a 1031 like-kind exchange.

1031 Exchanges Defined for Investors

A 1031 exchange allows an investor to sell and reinvest the proceeds in a similar qualifying property to defer paying any taxes. This like-kind investment property exchange helps real estate investors maximize their investment’s overall value by avoiding tax bills.

By following the investment property sale and reinvestment rules of the 1031 exchange transaction, real estate investors defer the:

1.     Capital gains tax on real estate investment property sale proceeds

2.     Depreciation recapture tax (based on deductions taken in previous tax years for the property’s depreciation costs)

Otherwise, without a 1031 exchange, you could have instant tax liabilities from your investment properties.

To maximize your real estate investment, 1031 exchanges offer significant benefits. For the vast majority of investors, the tax savings through 1031 exchanges more than justify navigating the complex IRS qualifying requirements through professional tax and accounting advisors.

When Can a 1031 Exchange Apply?

Generally, investors use 1031 exchanges to sell real estate investment properties without tax consequences. When the investment property, also known as the relinquished property, is sold, the proceeds must go directly to invest in another real estate investment property.

Each related investment exchange transaction must be closely monitored as qualifying. Taxes are only deferred so long as profits are reinvested in qualifying real estate investments.

Since the Tax Cuts and Jobs Act, 1031 exchanges are restricted to real property used in business or as an investment only. Now, the personal or intangible property does not qualify unless sold before the end of 2017.

You can set up a 1031 exchange with multiple properties. For example, some investors transition from one property to several properties of split values through a 1031 exchange. This can help boost cash flow and diversify your operations by spreading out to several locations.

Even when selling one investment property to purchase several of lesser values, a 1031 exchange can help you defer any tax bills for gains.

The other tax scenario where a 1031 exchange is helpful involves the depreciation of your investment property’s value. When this deduction is claimed for investment property income, you have to pay tax on the difference between the depreciated value and the property's actual sale price.

A like-kind property exchange avoids a tax bill for depreciation when you sell an investment rental property or even a property used as a business office.

Why Are 1031 Exchanges So Popular With Real Estate Investors?

The advantages of 1031 exchanges are understandably appealing. Who wouldn’t want to avoid paying any capital gains taxes on the sale of investment or business property?

On top of the strong cost-saving incentive, a wide range of investment or business transactions are eligible for 1031 exchanges. So many typical examples of investment or business property meet the qualifications as an eligible asset for exchange.

Also, keep in mind that the exchanged properties may not have to be as similar as you’d think.

How to Set Up a 1031 Exchange?

As the owner of a real estate investment property, you’ll need to plan beyond selling your house fast to meet the IRS deadlines on closing on the replacement property.

Real estate investors trying to navigate a 1031 exchange on both sale and purchase requirements find significant value in having a transaction coordinator's general oversight of the transactional details. This helps coordinate your full real estate investment exchange's broader aspects beyond the property-specific guidance that a real estate agent offers.

Mandatory IRS Qualifications for a 1031 Exchange

The IRS like-kind exchange rules (found in Publication 544) limit 1031 exchanges to qualifying investment or business property with additional conditions on how they can be sold and purchased.

What Are the Required Steps for 1031 Exchanges?

These steps are for a basic delayed response 1031 exchange, the most common process for investors:

  1. Plan the transaction with professionals.
  2. Execute the sale and purchase agreement of your investment property by a buyer.
  3.  The buyer transfers the purchase money to your qualified intermediary to be held in escrow.
  4. You have 45 days to identify your investment property to purchase of at least equal value.
  5. You must transfer the new purchase money through your qualified intermediary to the new seller and close within the next 180 days.

How to Handle Tax Reporting Requirements for 1031 Exchanges?

Investors complete and file an IRS Form 8824 for certain like-kind exchanges of business or personal property.

When the replacement property value is greater than the sale proceeds, the investor will owe dividend recapture and capital gains tax on the difference. Those surplus sale proceeds that are not reinvested are called boot.

Can a 1031 Exchange Potentially Defer Tax Liability Forever?

The ultimate goal of a 1031 exchange is for any deferred tax liability to be eliminated when your heirs inherit the property from your estate.

Of course, any failure to meet IRS qualifications can result in extra tax consequences. This unfortunate outcome is exactly why it pays to have a qualified accountant structure your like-kind exchange correctly at the outset.

Take Advantage of a 1031 Exchange

In short, a 1031 exchange could help you avoid taxes when you sell a rental property and properly reinvest the sale proceeds. The goal is to properly and indefinitely defer capital gains tax. The key is the exchange of like-kind investment properties. Of course, the assets sold and purchased must be timely transferred and through a qualified intermediary.

Remember, while strict, the Section 1031 requirements should not deter you from claiming these substantial tax benefits as part of your full real estate investment plan. Make sure your investment property exchange strategy qualifies as a tax-deferred reinvestment under Section 1031.

Set up a real estate investment plan that defers your tax liability and offers plenty of options with the right experts in place right away.

You’ll make significant progress in structuring your tax-advantaged real estate investment with these initial steps — retaining a certified accountant, reviewing your plan with a qualified tax professional, working with top-quality real estate agents, and learning how to find a qualified intermediary.

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Ben Mizes is the co-founder and CEO at Clever Real Estate, the nation's leading real estate education platform for home buyers, sellers, and investors.