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How a 1031 Exchange Works

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Investing in real estate can offer a hedge against inflation while helping you create a diversified portfolio. If at some point you decide you want to shift your real estate investment dollars, you may consider a 1031 exchange. This type of exchange allows you to defer paying capital gains tax on the sale of an investment property when the proceeds are used to buy another similar property. A 1031 exchange can be a useful tax planning tool, but there are certain rules you need to know to make sure you’re approaching it the right way. For further hands-on guidance, consider working with a financial advisor.

What Is a 1031 Exchange?

The 1031 exchange allows you to sell or use the funds you receive from the sale of an investment property to invest into another property without paying capital gains immediately. Section 1031 of the Internal Revenue Code specifies what constitutes a 1031 exchange:

“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”

So if you use the 1031 exchange then you don’t have to report capital gains or pay taxes on them to the IRS. Previously, you could use 1031 exchanges for investments other than real estate, such as machinery or business equipment, collectibles, artwork or patents. The Tax Cuts and Jobs Act, however, changed the 1031 exchange guidelines so they’re now limited to real property only.

How a 1031 Exchange Works

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The mechanics of a 1031 exchange are relatively simple. If you own an investment property that you’re able to sell at a gain, you could use the proceeds to buy another investment property. No tax would be due on the gains from the sale.

The key thing to note about a 1031 exchange is that the IRS is very specific about what you can and can’t exchange. Only like-kind property exchanges are allowed, which for IRS purposes means properties that are “of the same nature or character, even if they differ in grade or quality.”

According to the IRS, a like-kind exchange can happen regardless of whether a property has undergone improvements or not. But for it to fit the bill, the properties have to be similar. For example, if you own a duplex or apartment building and exchange it for another duplex or apartment building, that’s a like-kind exchange.

But you wouldn’t be able to use a 1031 exchange to sell a property you own in the U.S. and buy property in Canada on a tax-deferred basis. Here are some other assets that can’t be used in a 1031 exchange: Property bought for resale; land under development; a personal residence; and, generally, a home bought to be fixed and “flipped.” There is no limit to how many times you can do a 1031 exchange.

Facilitating a 1031 Exchange

Aside from following the like-kind rule, 1031 exchanges also have to go through the proper channels. That means having an exchange facilitator to help throughout the process. The IRS doesn’t allow you to perform 1031 exchanges on your own.

The exchange facilitator can be a qualified intermediary or another person who holds exchange funds for you as part of an escrow, trust or exchange agreement. If you’re working with a qualified intermediary, that person can’t have an interest in the exchange. So you can’t use your real estate broker or agent or a relative to facilitate the exchange.

It’s the intermediary’s job to oversee the sale of your old property and the purchase of a new one, holding the proceeds of the sale in escrow in the meantime. The intermediate or facilitator must also make sure that the entire process is accurately documented so it can be reported to the IRS for tax purposes. It’s also worth pointing out that the facilitator is paid a fee for his or her services.

Other fees to be aware of include:

These costs can be paid using funds from the exchange. But you can’t use 1031 exchange money to pay property taxes, insurance premiums or repair and maintenance expenses.

Keep in mind also that all of this has a timeline that must be followed. The IRS allows you 45 days to identify a potential replacement property for the one you’re planning to sell. You have 180 days to purchase the new property and the entire exchange has to be completed within a 180-day window (which includes the 45-day period to find a property) for you to qualify for a tax break.

Benefits of a 1031 Exchange

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The main advantage of a 1031 exchange to you is the opportunity to defer paying taxes on capital gains associated with the sale of an investment property. That may be something you’re interested in if you’d rather avoid paying capital gains tax at the higher short-term rate.

A 1031 exchange can also be useful in building out a portfolio of multiple investment properties. For example, it’s possible to exchange one property asset for multiple properties or vice versa, exchanging several properties for a single real estate investment. You can use a 1031 exchange to tailor your property investments to fit your needs and goals where returns are concerned.

It’s possible to trade up or down while enjoying more flexibility than you might with other real estate investments. For instance, with real estate crowdfunding or real estate investment trusts (REIT), you generally have very little flexibility in terms of timing your exit. And REITs can lack transparency when it comes to the underlying investments.

Using 1031 exchanges to manage investment properties means you can choose when to time your exit from one property and entry into another. And as your properties appreciate, you can benefit from an increase in your equity in those holdings.

One important thing to keep in mind, though, is that you may still owe taxes on a 1031 exchange if you’re receiving a cash benefit from the transaction. So, for instance, if you sell a property that has a $1 million mortgage and buys a new one that only has a $750,000 mortgage, the $250,000 gap would be considered a capital gain to you and would thus be taxable.

Rules for Exchanging Depreciable Property

If you are using the 1031 exchange with a depreciable property then there are certain rules that you need to be aware of. This type of activity can trigger something known as depreciation recapture, which is a profit you receive that is taxed at your ordinary income level.

You may be able to avoid this type of recapture tax obligation if you exchange a single property for another. However, if there are significant differences in your exchange then the recapture rule will trigger your tax liability. For example, if you exchange unimproved land without any buildings on it for an improved piece of land that has a money-making building, then the tax requirement will be triggered.

When this is triggered you will essentially be required to pay tax on the depreciation that you’ve previously claimed on the property that you originally owned before the exchange. This can be a complicated part of 1031 exchanges so it’s important to consider consulting with a financial advisor to help you with any transactions.

Bottom Line

A 1031 exchange could help you minimize tax liability when trading one investment property for another. Making sure that you’re following the IRS guidelines carefully matters to avoid an unexpected tax bill. If you’ve never attempted a 1031 exchange before you may want to talk it over with a tax or real estate professional before moving forward.

Tips for Investing

  • Consider talking to a financial advisor about the ins and outs of completing a 1031 exchange if you own an investment property. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have free introductory calls with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • There are different paths you can take as a real estate investor and it’s helpful to consider all the options. For example, you could invest in a crowdfunding platform, a REIT or real estate mutual fund. Looking at the pros and cons of each one can help you decide which one most closely fits your risk tolerance and goals.

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