1031 Exchange Basics

We wrote an article several months explaining some of the aspects that make real estate investing attractive.  One such aspect is the ability to defer taxes by engaging in a 1031 exchange. 

Named for Internal Revenue Code section 1031, a 1031 exchange allows an investor to sell an investment property (Relinquished Property) and avoid paying taxes by buying another investment property (Replacement Property).  It’s a great tool to defer taxes, expand your real estate, and increase wealth, but it comes with some strict rules you must follow to qualify.

1031 Basics Rule #1 – Timelines

A 1031 exchange has strict time lines an investor must follow in order to qualify for a 1031 exchange. First, is that the investor has only 45 days from the closing date on the Relinquished Property to identify up to three Replacement Properties.  Second, the investor must close on the Replacement Property within 180 days of closing on the Relinquished Property. 

1031 Basics Rule #2 – Replacement Property Requirements

Rule 1031 provides that the Replacement Property meet certain requirements.  First, the value of the Replacement Property or Properties must exceed that of the Relinquished Property.  Additionally, if you have an existing mortgage on the Relinquished Property, your mortgage must be greater on the Replacement Property. Otherwise, you’ll get taxed on the difference.

Second, the Replacement Property must be a “like-kind” property.  While this sounds restrictive, it’s actually pretty broad.  For example, you could exchange a duplex building for an apartment building, vacant land to develop, or an office building.  But you couldn’t sell an apartment building to buy a single family home to live in immediately as your primary residence.

1031 Rule #3 – Use of intermediary

In order to qualify for a 1031 exchange, the investor cannot touch the proceeds from the sale of the Relinquished Property.  Rather he/she must use an intermediary who will hold the funds from the sale the distribute them to make the purchase of the Replacement Property.  

1031 Basics – Practical tips

The biggest hurdle to successfully completing a 1031 exchange is meeting the strict timelines.  An investor can more easily meet these timelines by getting a Replacement Property under contract prior to closing on the Relinquished Property. 

1031 Basics – an example

We’ll use round numbers and not include cost of sale (typically 6-7% of sale price) to make the math easier for me. You’ll still understand the concept.

Let’s say Ed bought an investment property many years ago for $100k.  It’s been depreciated $20k. Meaning his current tax basis is $80K.  The property is now worth $500k and Ed owes $50k on his mortgage.  If Ed were to sell the property for $500K, he’d owe taxes on $420k (basis + gain). $400k of that would be at the capital gains rate (current max of 20%). $20k, the amount depreciated, would be taxed at the ordinary income tax rate at approximately 25% (the actual rate will vary depending on the taxpayer). 

So Ed would owe around $85K in federal taxes plus whatever his state taxes him.   He could pocket $365k ($500k-$50k (mortgage)-$85K(taxes)). That’s not too bad.  But he could instead 1031 those proceeds ($450k) to buy an $1million + investment property that will cash flow and appreciate. One way to look at it is, by taking advantage of the 1031 exchange, Ed gets Ed an $85K interest free loan of indeterminate length from Uncle Sam.

1031 Basics – Pros/Cons

As the above example demonstrates. Using a 1031 exchange is a great way to defer taxes and increase wealth. 

However, it does have some drawbacks.  First there’s the strict timeline requirement.  This means you may be in a situation where you’re forced purchase a Replacement Property that is less than perfect before you run out of time.  Second because of the timelines, your negotiation position during the closing period on both properties may not be as strong as it otherwise could be.  For example, you may be forced to concede more during your inspection reconciliation process than you otherwise would just so that your deals don’t fall apart.   Third, in a hot market like we’re in right now, having a 1031 contingency when trying to buy your Replacement Property will make your offer less attractive to a potential seller and may require you to offer more than you otherwise would in order to get the property.  Finally, because you’re selling/buying in the same market, it may be difficult to sell high and buy low.

Conclusion

While there are some drawbacks to consider, a 1031 exchange makes a great tool to defer taxes, expand your real estate holdings, and increase wealth.  Of course, when/if you ever sell you’ll have to pay the tax man.  But when you die, your heirs get the stepped-up basis (under current law) and can sell without paying any tax.  Hopefully, they’ll at least raise a toast in your honor.

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