What is a 1031 Exchange and How Does It Work?

Prestigious firm Ernst & Young recently put out a study showing that 1031 exchanges support over $4 billion in investments and employ over 500,000 people each year. So why is a 1031 exchange such a big deal? 

Investing in real estate requires knowing what fees and taxes go with your investments. A 1031 exchange can help you defer taxes, specifically capital gains taxes stemming from the sale of an investment property. 

In practice, using the 1031 exchange rules allows investors to put off paying taxes on profits they made from selling an investment property. However, 1031 exchanges come with several caveats and requirements investors must meet to legally defer taxes. 

You’ve heard the term “1031 exchange” thrown around enough. Now it’s time to really dig into what that phrase means and how you can use it to your advantage. 

Are you ready to find out what a 1031 exchange is and how it works? Let’s get started!

What is a 1031 Exchange

Section 1031 of the Internal Revenue Code (IRC) spells out exactly how this type of real estate exchange works, which is how the phrase “1031 exchange” was coined. Some might even consider it one of the first lessons in any course on real estate investing for beginners. 

The point of a 1031 exchange is to defer capital gains taxes to essentially keep more of your profits, with the intent of reinvesting them. Rather than paying your dues (i.e. taxes) with the first sale, you’re deferring those taxes until you no longer meet the requirements. 

As simple as that sounds, a 1031 exchange has a lot of moving parts to deal with. Investment properties must be like-kind (which is in itself not as clear-cut as it sounds) and you must consistently show that the properties you invest in are for investment purposes only. 

If you’re now sure how to start investing or even how to raise money for real estate investing, using a 1031 exchange can help you get the ball rolling.

If you use it with vacation homes, it can also be a great way to travel cheap or even take a cross-country road trip on a budget. 

Like-Kind Investment Properties

Buying a vacation rental property can be a good way to get into the real estate investment game, but it’s not as easy to use a vacation rental as a tax break under the 1031 exchange rules. Let’s break down the term “like-kind” investment properties to understand why. 

Under Section 1031 of the IRC, a like-kind property qualifies not based on size or other physical characteristics. Instead, it’s the intent to use the property for business or investment purposes that satisfies the basic requirements in the eyes of the IRS. 

For example, vacation home rentals can qualify as a like-kind property if your company is in the business of acquiring, renting, and then selling Airbnbs. However, should you attempt to fund your new vacation home (for personal use) and defer taxes under the 1031 exchange rules, you’d have to meet specific requirements to do so (more on that below). 

Many of the most lucrative real estate side hustles involve leveraging the tax breaks of a 1031 exchange to continue building profit through selling and acquiring real estate. You can use a 1031 exchange as many times as you want as long as you continue to qualify. 

Satisfying the requirements of a 1031 exchange also means placing proceeds from the sale of the first property in the hands of a third party. You cannot hold these proceeds at any point, even when it comes to purchasing your next property. 

We’ll talk more about how third-party 1031 exchanges work in a moment. What you should remember about 1031 exchanges is that you’re not avoiding capital gains taxes completely. 

Instead, you’re putting off paying capital gains taxes until a later date. In some cases, that can mean deferring payments of 15-20%, depending on your income and other factors. 

Reverse Exchanges

To make things even more confusing, 1031 exchanges can be done in reverse, albeit under certain circumstances. These are called reverse exchanges. 

In a reverse exchange, you’ve already purchased the replacement property before selling your first one. You can still qualify for a reverse 1031 exchange as long as you’ve completed the same actions in the same timeframe as you would for a regular 1031 exchange.

The catch is that to fulfill the time requirements, you’ll still need to sell the first property within 180 days of purchasing the replacement property. You’ll also have to designate the second property as the one completing the 1031 exchange within 45 days of purchasing it. 

What Types of Properties Qualify For a 1031 Exchange 

Let’s talk briefly about the types of properties you can use under a 1031 exchange. We’ve mentioned they have to be like-kind, but here are a few examples:

• You exchange an investment of raw land for a strip mall 
• You acquire a new investment property as a business and exchange it for the old one
• You sell your first vacation home and reinvest in another to continue renting it 

It’s important to note that both properties must be within the United States to qualify. You can potentially use your primary residence to defer taxes under a 1031 exchange, but again, there are certain requirements you’ll need to meet. 

1031 Exchange Specifics 

You may have heard of 1031 exchanges called delayed, third-party, or Starker exchanges. These terms all describe basically the same thing. 

Let’s take an example of a 1031 exchange to give this discussion context. Suppose you have an investment rental home that you want to use as your stepping stone to setting up a 1031 exchange. 

The first step would be finding an intermediary qualified to not only hold the funds from the sale of your investment property but also work with you to find a replacement property to purchase. The important distinction here is that you do not receive the funds in any way. 

From the date of sale of your first investment property, you have 45 days to designate a replacement property. You can list three or more properties but you must close on one of the properties listed to complete this requirement. 

In addition, within 180 days from the sale of the investment property, you must also close on that replacement property. These two timelines (45 days and 180 days) are concurrent, so keep this in mind when you plan. 

As long as each subsequent investment property purchase is like-kind, designated within 45 days, and closed on in 180 days, you’re golden under the 1031 exchange rules. Keep that momentum going to continue deferring your tax payments. 

The only way you can avoid your tax bill completely is to fail to continue the pattern by dying. Your heirs will still inherit the investment property but they won’t be held liable for the deferred capital gains taxes. 

Leftover Cash

Profiting from investment properties under 1031 exchange rules is possible. However, you’ll need to wait 180 days from the sale of your first investment property to claim that profit from your trusted intermediary. 

Most real estate investors refer to this profit as the “boot,” which is taxed as capital gains. On the other hand, if your investment liabilities decrease, you’ll still be subject to taxes.

To further complicate the mix, any loans or debt on both properties can balance out the numbers in various ways as well. Keep this in mind as you move from one property to the next under the 1031 exchange rules. 

Vacation Homes

Saving for a house is one thing, but owning a vacation home can be a great way to get away and not have to pay for a hotel. Using your vacation home as an investment property under a 1031 exchange, however, might cause you to want another vacation after all the stress. 

It used to be that you could swap one vacation home for another, make that new property your primary residence, and sell it after living there for two out of five years of ownership without having to pay capital gains taxes on profits of $500,000 or more. As of 2004, Congress closed the gap to make it more difficult.

Current requirements rely on the same “investment property” definition to qualify properties for a 1031 exchange. That means you’d need to rent out the investment property for a large portion of the year to ensure it meets eligibility requirements. 

Safe Harbor Rule

Fast-forward to 2008, when the IRS agreed it wouldn’t challenge the validity of a replacement property as an investment property. However, this “Safe Harbor Rule” required property owners to rent it out for the majority of two years. 

The IRS specifically states you have to rent out your investment property at a fair price for 14 days or more and that your use of the property cannot exceed either those 14 days or 10% of the time the property is rented (whichever is greater). Since fair rental rates depend on location, these requirements are vague enough to give investment property owners some wiggle room. 

Let’s say that you wanted to use the Safe Harbor Rule to avoid paying capital gains taxes on a property you want to call home. You can still acquire the property under 1031 exchange rules but there are a few differences. 

For instance, you can convert your final replacement investment property to your primary residence. To shield yourself from capital gains taxes up to $500,000, you’d need to hold the property for more than five years.

This five-year buffer period only applies if you sell the property as your primary residence. 

Recent Changes to Section 1031 Rules

With its popularity and obvious benefits, 1031 exchanges have been popular in recent legislation. Though it remained unchanged within recent years, the Tax Cuts and Jobs Act (TCJA) of December 2017 limited the use of 1031 exchanges on various types of property. 

As it stands now, 1031 exchanges only come into play with real estate. Other types of personal property are no longer covered. 

Reporting 1031 Exchanges to the IRS

As with any other type of tax break, 1031 exchanges require documentation to prove to the IRS that you’re operating on the up-and-up. You’ll notify the IRS of your intent to use a 1031 exchange for your investment properties with Form 8824. 

File Form 8824 in the same year you made the exchange. You’ll need to fill out paperwork describing various aspects of both properties, from specific dates of purchase, transfer, and ownership, to the value and description of each property. 

Completing this 1031 exchange form accurately can help you avoid auditing. Some investors choose to hire a company to handle all the paperwork, considering it can get complex very quickly. 

1031 Exchange FAQs

Fund Your Future with a 1031 Exchange

Real estate investing is not for the weak of heart or those with a small risk appetite. This is especially true if you want to take advantage of the 1031 exchange rule to provide momentum for your real estate investing endeavors. 

We hope this article on 1031 exchanges has helped clear up the confusion surrounding this specific type of tax break. For some, it can be one of those processes that makes more sense the first time you go through it, but even that can be too much risk for more conservative investors. 

At the same time, a 1031 exchange can give you the break you need to get your real estate investment business off the ground. Use the 1031 exchange rules to your advantage to get ahead and potentially leave your family a legacy they can enjoy and build on. 

Real estate investing is just one way to improve your life and your finances. How will you use a 1031 exchange to achieve your financial goals?