What Is a 1031 Exchange and How Does It Work?

Looking to sell an investment property but want to skip the capital gains tax? A 1031 exchange might be the answer for you.

A 1031 exchange allows you to avoid paying capital gains tax when you sell an investment real estate property if you reinvest those profits into another qualified property within a certain time frame. The official name used by the IRS under IRC Section 1031 is like-kind exchange.

Keep in mind—this is tax-deferred, not tax-free. We’ll dig more into this in a bit, but if you’re not super careful, you could trigger the capital gains tax . . . which wouldn’t be fun.

How Does a 1031 Exchange Work?

So, let’s say you bought a real estate property five years ago. During that time, the property’s value went way, way up and you sold it this year for a $300,000 profit (after any commissions or closing costs paid). Not too shabby!

If your long-term capital gains tax rate is 20%, that means you’d owe $60,000 on the sale of that property. Boo! But thanks to the 1031 exchange, you can reinvest the profits into another investment property (that costs the same or greater than the property you just sold) and avoid paying those taxes altogether. 

Just a side note: 1031 exchanges do not apply to primary residences. However, you could swap a former primary residence or vacation home under very specific conditions.

 For example, let’s say you have a lake house that you decided to turn into a rental property. You’ve had a tenant living there for the past year, but now you want to sell it and buy another rental property. Would that qualify for a 1031 exchange? As long as you can show the IRS that you’ve been using the property for business purposes, you shouldn’t have any problems!   

How to Do a 1031 Exchange

Listen up! There are certain rules you need to strictly follow and deadlines to meet on time for a swap of properties to qualify as a 1031 exchange. If you’re not careful, it could lead to a nasty Tax Day surprise . . . and trust us, you don’t want that to happen!

When you boil it all down, here are the five basic steps to completing a 1031 exchange.

1. Choose a qualified intermediary to coordinate the exchange.

Since the money received from selling a property is taxable, you technically can’t receive that money when you sell your property. If you do wind up taking control of the cash at any time before the exchange is complete, it could disqualify the entire transaction as a like-kind exchange, and you’ll owe taxes on all of your capital gains.

Ouch. See? Not fun.

Connect with an investing pro who gets this stuff. See up to five for free.

That’s why you need a qualified intermediary to help with the exchange (you’re not allowed to do it yourself). This person will act as a middleman for the 1031 exchange, and they’ll hold on to the proceeds from the sale of your property while you look for a new one.

(We’ll break down who can be a qualified intermediary and where to find one below.)

2. Sell your current real estate property.

One you have a qualified intermediary in place, then you can sell your investment property. But fair warning: You only have a small window of time to identify and eventually close on a replacement property. Once you sell your investment property, the clock starts ticking . . . so get moving!

3. You have 45 days to identify potential replacement properties.

Next, you have to come up with a small list of possible properties you plan to buy to replace the one you just sold. Don’t wait too long, though. You have just 45 days from the day you sell your property to identify potential replacement properties.¹ And there are no extensions to this deadline!

Once you’ve identified the potential properties, the identification has to be made in writing and signed by you. Then you’ll need to deliver that identification to someone involved in the exchange—that could be the seller of the replacement property or your qualified intermediary.²

4. You have 180 days to close on a replacement property.

Here’s the fun part! Once you’ve found a property you like, you’ll use the funds from the sale of your other investment property to purchase your new property. Touchdown, baby! But remember: You have just 180 days (that’s roughly six months’ time) from the day you sell your property to close on your replacement property.³

5. File IRS Form 8824.

Once you’re done celebrating your new property, it’s time to fill out some paperwork (we know . . . so much fun!). You will need to fill out Form 8824, which is used to report like-kind exchanges of business or investment properties.

Since 1031 exchanges can get really complicated really quickly, working with a qualified tax advisor who can help you get all the details right can take a lot of the stress out of the process.

Types of 1031 Exchanges

There are four main types of 1031 exchanges: delayed, simultaneous, reverse and build-to-suit. Here they are laid out:

Delayed Exchange

A delayed exchange is basically what we’ve broken down above—the seller has 45 days to find a new replacement property and 180 days to close. It’s the most common type of 1031 exchange since it gives property investors time to plan.

Simultaneous Exchange

A simultaneous exchange is when the sale of an old property and the purchase of the new property happen on the same day, at the same time. This can be challenging to pull off as it requires spot-on timing.

Reverse Exchange

A reverse exchange is exactly what it sounds like—a 1031 exchange in reverse. Here’s how it works: You buy a new property before you sell your old investment property. This can be a great option if you find a property you really want, but you don’t want to hold off and lose it in a competitive market.

However, there are risks here. You’re still subject to the time limit (180 days to complete the sale of your old property), and it could cost more than the traditional route—often requiring additional paperwork and professional help.

Build-to-Suit Exchange

Found a new property that needs a little TLC? A build-to-suit exchange (also known as a construction or improvement exchange) might be your best bet. This type of 1031 exchange allows you to sell an investment property and use some or all sale proceeds to build or improve a new property while deferring taxes.

But remember, you still have to complete the entire transaction in the 180-day time limit, and you’ve got a whole lot more to manage and keep tabs on (construction and renovation costs, labor, permits, architects, etc.)—so make sure you’re prepared.

Choosing a Replacement Property for a 1031 Exchange

When you do a 1031 exchange, the swap has to be between what the IRS calls like-kind properties. Hence the name. Basically, that just means that both properties—the one being sold and the one being purchased—must be used for business or investment purposes.

So what kind of property (or properties) meet the IRS requirements for a 1031 exchange? Here are a few important guidelines to follow when you choose a replacement property:

Section 1031 exchanges are limited to real property only.

As of January 2018, like-kind exchanges are limited to real property, which means land or anything permanently attached to it (like buildings, for example). Personal property such as machinery, vehicles, artwork, patents and intellectual property do not qualify for a 1031 exchange.⁴

Properties don’t need to be the same type.

For example, you can exchange raw land for a rental house, or an office building for an apartment complex. As long as they’re being used for business or investment purposes, you’ve got the green light.

Properties can be located anywhere in the U.S.

Maybe you’re moving to Florida, and you want to sell a property you own in New York so you can purchase one in the Sunshine State. That’s not a problem—in fact, you can exchange like-kind properties from anywhere in the U.S. of A.

An exchange can include multiple properties.

Do you want to sell one property and use the profits to buy three different properties? As long as they’re all used for business or investment purposes, there’s no problem there.

The replacement property (or properties) must be of equal or greater value than the one being sold.

If you want to defer all of your capital gains taxes, the replacement property you buy has to have a purchase price that is equal to or greater than the property you sold. If the replacement property is worth less than the one you sold, you’ll have to pay taxes on the difference. 

Need help finding replacement properties? A top-notch real estate agent in your area can help you find those properties and close on them within those deadlines you need to meet.

What Is a Qualified Intermediary?

Like we warned about earlier, if you want to defer the capital gains taxes you owe, you’re not allowed to receive the proceeds of the sale directly. That’s where a qualified intermediary comes in.  

This qualified intermediary will sell the property on your behalf and receive the proceeds from the sale for you. They’ll keep those funds in an escrow account with their financial institution until you’re ready to buy the replacement property.

Once the purchase is complete, they’ll transfer the deed over to you—and that’s it! If there are any proceeds left over from the exchange, the qualified intermediary will return those funds to you.

Who Can Be a Qualified Intermediary?

So, who can be a qualified intermediary? Here are some examples of professionals who probably have the ability to act as a qualified intermediary during a 1031 exchange:

• Real estate agents
• Investment professionals
• Employees
• Attorneys
• Certified Public Accountants (CPAs)

Unfortunately, you can’t be your own intermediary, and you can’t pick someone who’s related to you (sorry, Uncle Bob) or who has acted as your agent in the past two years.

How Do I Find a Qualified Intermediary?

Don’t know where to look for a qualified intermediary? You can start by talking to a real estate agent or tax professional about the possibility of acting as a qualified intermediary on your behalf.

There are also plenty of companies and organizations out there that can connect you with a qualified intermediary and other 1031 exchange services. The Federation of Exchange Accommodators (FEA) has a qualified intermediary certification program with a directory of its members you can reach out to.⁵ 

Work With Pros You Can Trust

As you can see, there are lots of strict rules and guidelines to follow for a property swap to qualify as a 1031 exchange. All it takes is one misstep to unravel the whole thing! That’s why you need to work with a professional you can trust to walk you through the process.

The good news is, our RamseyTrusted^® program can connect you with qualified tax pros and the best real estate agents in your area. With their help, you can rest easy knowing that your exchange is in the hands of professionals you can trust!

 

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.