What Is a 1031 Exchange? How Real Estate Investors Can Put Off Paying Capital Gains
Anyone new to real estate investing may hear some terms thrown around that they may not fully understand. One of these terms is the “1031 exchange,” which is a common tax strategy that can help real estate investors expand their portfolios and raise their net worth.
If you plan to sell an investment property and want to defer paying a barrage of taxes—including capital gains—a 1031 exchange may suit your needs. We spoke with experts to get answers to common questions surrounding the 1031 exchange.
What is a 1031 exchange?
A 1031 exchange may sound obscure, but the concept is fairly straightforward.
“The term ‘1031 exchange’ gets its name from the Internal Revenue Service code, Section 1031,” says Eachan Fletcher, CEO and co-founder at NestEgg.rent.
This section allows for the seller of an investment property to defer paying capital gains by using the proceeds from that property to buy a replacement investment property.
What are the benefits of doing a 1031 exchange?
As an investor, there are some reasons why you may consider using a 1031 exchange. You may be seeking a property that has prospects for better revenue return or you may want to diversify your assets.
“The benefit is that an investor wouldn’t have to pay taxes on the capital gains—aka appreciation—on their home,” says Andrew Lueong, co-founder and CEO at Doorvest. “This means that they can keep usually upward of 20% of their appreciation and use it toward their next property.”
What are the requirements for a 1031 exchange?
There are rules and regulations to be aware of when doing a 1031 exchange, and experts recommend consulting your accountant before pursuing this type of transaction.
“The real property you are purchasing should be ‘like-kind,’ or also used for investment purposes, to the one you are selling,” says Sarah Minton, real estate agent for Warburg Realty.
The IRS says properties are of like-kind even if they differ in grade or quality or are improved or unimproved. For example, an apartment building would generally be like-kind to another apartment building.
Lueong says the “like-kind” exchange does not have to take place simultaneously and that a delayed exchange “can occur while one party decides what home they want to receive for their old home.” However, a qualified intermediary is required to facilitate the exchange and must be a non-related third party, which means the intermediary can’t be an agent, broker, accountant, lawyer, banker, etc., who has provided you tax, legal, accounting, or financial services in the past two years, he says.
Minton says other rules include having to adhere to strict timeline requirements set by the IRS.
“You have 45 days to identify in writing a replacement property and 180 days to acquire said property,” she says.
Who qualifies for a 1031 exchange?
People with investment properties qualify for a 1031 exchange.
“Any investor-owner of income-producing real property can qualify for a 1031 exchange into new income-producing property,” says Fletcher.
Lueong says personal property does not qualify.
How many times can you do a 1031 exchange?
Fletcher says there is no limit on how many times or how frequently an investor-owner can do a 1031 exchange.
Still, “the question of ‘how often’ is a gray area in the IRS code,” Lueong warns. This is another reason why consulting your accountant is a must.
“It should be noted that a 1031 exchange does not eliminate capital gains—it just defers it,” says Minton. “You will eventually have to pay capital gains when you sell real property for cash.”
What if the owner decides to make the investment property their primary residence?
Michael J. Franco, an attorney, investor, and broker at Compass, says owners who make the investment property their primary residence won’t meet the requirements of a 1031 exchange, and it could and/or should trigger current capital gains tax.
“If they hold it as an investment for two years then convert it to primary residence, they will end up with a ‘transferred basis’ from the old relinquished property, which could still trigger capital gain on a primary residence if the gain exceeds the threshold for tax exemption for primary residence sales—$250,000 for singles and $500,000 for married couples filing jointly,” says Franco.
How does a 1031 exchange affect house flippers?
Good news for house flippers: They qualify for a 1031 exchange, with a few conditions. Franco says the property must be owned for two years for it to qualify, so if owners flip too fast it won’t work.
“Due to the relatively short holding period for a flipper, it is unlikely that the house achieved a significant appreciation to warrant use of the 1031, but there are no disqualifications for being a flipper,” says Lueong.
“You can keep on exchanging into another property to flip; however, you run into risk where the price of your exchange property will continue to go higher,” says Edward Pan, first vice president of Pacific Partners Investment Team, Multi-Family Investment Group.