What is a 1031 exchange?
A 1031 exchange in real estate allows you to change your investment type without “cashing out” the capital gains. This allows your investments the chance to keep growing without taxes. The 1031 exchange applies across different kinds of real estate, including residential, commercial, industrial, special use, etc., and can be used anywhere within the United States.
The 1031 exchange derives from Section 1031 of the United States Internal Revenue Code. It’s a provision that allows people to avoid paying capital gains taxes when they sell investment properties, as long as they reinvest the sale’s proceeds within a predetermined amount of time into a property of equal or greater value.
There are no limits in place for how frequently an investor can use 1031; you can keep rolling your investment from one property to the next and the next and the next, etc. Even if each swap provides you with profit, you won’t have to pay taxes until you sell the investment for cash down the road.
If all goes to plan, you’ll only have to pay one long-term capital gains rate tax, ranging from about 15-20%. The tax can be as little as 0% if you’re considered low-income.
So, how does the 1031 exchange work? Here’s how to complete the process:
- Choose a reputable intermediary to coordinate the 1031 exchange (you’re not permitted to DIY this), who will act as a middleman who holds on to your sale proceeds while you look for a new property.
- Sell your current property.
- You have 45 days to find potential replacement properties. There are no extensions available. Once properties have been identified, sign off on them and hand the identification to your broker. The replacement property you end up choosing has to be on the list in order to use the rule.
- You have 180 days to close on your replacement property.
- File IRS Form 8824.
1031 exchange case study
Jermaine sells his beachside investment home for $600K. He had a $400K mortgage on the home when he sold it. He finds a new investment property on the same beach he wants to buy for $800K, and wants to keep his mortgage the same as before while deferring his capital gains taxes. So he uses $200K from his savings account, plus the proceeds from the previous sale, to purchase his new beach house with $400K cash and a $400K mortgage. As this satisfies all 1031 exchange requirements, Jermaine doesn’t have to worry about paying taxes on the sale of the old beach house.
The bottom line
The 1031 exchange helps people avoid paying capital gains taxes after selling investment properties if they reinvest the proceeds from the sale into another property of equal or greater value. This provision helps investors defer taxes on the gains of their investments. There are many other possible scenarios in which investors can use a 1031 exchange. But, the most important thing to remember is to apply the purchase price and debt financing rules to each scenario. These will help make sure you can, in fact, defer taxes or if some of the sale will be considered a “taxable gain.”