January 2, 2020

1031 exchange

1031 Exchange is a section of the Internal Revenue Code that allows people to defer tax on a qualifying exchange of like-kind real estate. 1031 exchanges are also known as a like-kind exchange or Starker exchanges.

A broad range of real and tangible personal property was originally included in like-kind property that is held for business or investment but, as of the start of 2018, the only permissible property is a business or real estate investment.

For real estate to qualify for 1031 exchange, it must be an investment property or for productive use in business and located within the United States.

You would use a 1031 exchange because it allows you to defer capital gain taxes. But, despite their benefits, they are not for everyone. Just like any other real estate decision, it’s important to consider the pros and cons when deciding if a 1031 exchange is the right option for you.

In this article, we are going to lay out some of the pros and cons of a 1031 exchange of real estate.

Rules of 1031 Exchange

There are several rules concerning a 1031 exchange property, including:

  • Federal and state capital gain taxes are deferred only when the value of the replacement property is equal to or greater than the property sold. Many people falsely believe that only the realized gain needs to be reinvested. This is not the case. Both the net equity and any debt retired from the sale must be reinvested if you plan to defer 100 percent of the gain.
  • You must engage a Qualified Intermediary to accommodate the exchange. It cannot be your CPA, attorney, realtor, financial advisor, or any related party, including your employee or blood relative. An exception is in a pure exchange in which the taxpayer and buyer want each other’s property but, even then, it still makes sense to use a qualified intermediary to ensure all 1031 exchange rules are followed. One other exception occurs when an attorney has provided services related to title closing. In this case, they are legally permitted to accommodate the 1031 exchange.
  • Taxpayers can never touch or have access to the exchange proceeds during the 1031 exchange. Should this occur, the funds become subject to taxation. In reality, if any of the exchange proceeds are touched, the exchange is over.
  • The taxpayer who sells is the taxpayer who buys. For example, one spouse cannot sell a property in their name and then have the spouse buy a property with the proceeds in their name. The transactions of the seller and buyer must line up. The non-buying and non-selling spouse can be quit-claimed or added to the replacement property title after the closing.
  • The 45-day time frame in which the new property must be purchased begins following the first leg closing. There are an additional 135 calendar days to acquire the replacement property, giving you a total of 180 calendar days to complete the transaction.

The 1031 exchange must be reported on Form 8824, Like-Kind Exchanges. The form includes reporting instructions.

Benefits of 1031 Exchange

Using a 1031 exchange offers several benefits, including:

It’s a Tax-Deferred Exchange

The primary reason people use the 1031 exchange is that it allows them to defer tax payments. You’re able to sell an investment property and reinvest that money in another property, deferring what you would have owed had you not re-invested in another property. You don’t need to deal with capital gains tax, which can be significant.

Leveraging and Increasing Cash Flow

Another benefit of using the 1031 exchange is that it allows you to leverage and increase cash flow for re-investing.

Since you aren’t paying the government on the sale of the property, you’re able to use that money toward your next investment. It gives you increased purchasing power and more leverage to invest.

You might be able to invest in a property with greater benefits than you would have if you’d been forced to pay taxes on the sale.

Relief from Investment Property Costs

If you sold a property that was a significant burden, you can sell it without worry about the taxes you would normally owe on it. This gives you relief from the cost of real property maintenance and management and helps you afford a property that, hopefully, comes with fewer issues.

Or, you can trade up for a property with an onsite manager to deal with issues.

Accumulation of Wealth and Assets

According to financial experts, 1031 exchanges are an excellent wealth-building tool and investment opportunity. Performing numerous 1031 exchanges over time and following exchange rules makes it possible to benefit from ongoing cash flow and net worth increases.

The benefits are greater than had you invested in real estate then sold that real estate and paid the taxes on it, especially if you do this over and over. If you can defer the tax owed each time you sell a property, it adds up to significant savings.

Theoretically, it might be possible to re-invest over a lifetime and leave the final properties to heirs and, depending on how the estate is structured, the tax burden might be eliminated. The loan is abolished upon your death so the estate never has to repay it.

Never Pay Taxes – Stepped Up Basis

Your beneficiary gets a stepped-up basis on the inherited property meaning their basis is the fair market value of the inherited property at the time of the taxpayer’s death. Should they choose to sell the property, the transaction is taxable only to the extent of the difference between the stepped-up basis and the net sale price.

It’s important to keep in mind that you won’t be pocketing the proceeds when you sell a property in a 1031 exchange. What you save in tax deferral compounds into the new investment. In the long run, though, the savings pay off and your net worth grows.

Drawbacks of 1031 Exchange

Despite the benefits of a 1031 exchange, there are a few drawbacks. These include:

Having to Follow Numerous Procedures, Rules, and Regulations

When you’re dealing with the IRS and benefitting in some way, don’t assume it will be easy. There are plenty of regulations related to a 1031 exchange. You’re being rewarded for investing back into property and as such, you need to follow the rules. If you don’t, you could face significant tax penalties.

It’s common to encounter roadblocks when trying to use a 1031 exchange. One of the most common problems is finding a replacement property within 45 days of the sale of the preceding property. Extensions are rarely granted. It’s important to meet with real estate professionals to structure 1031 exchanges so you aren’t penalized.

Dealing with Reduced Basis on the Acquired Property

When you use the 1031 exchange, the replacement property has a reduced tax basis. This is the purchase price less the gain deferred on the sale of the preceding property as a result of the exchange. If you ever sell the replacement property, the deferred gain will be taxed.

For many, this is the primary disadvantage of 1031 exchanges. The depreciation in the replacement property is reduced because the tax on the replacement property is calculated based on the purchase price of the replacement property minus the gain.

Inability to Recognize Loss

Since taxes are deferred, so are losses. If it’s a windfall profit year, deferring losses that can offset large profits is a painstaking decision. Weigh the benefits of the deferral against the downside.

Boost in Future Tax Rate

If you sell the investment property in the future, you’ll be hit with higher capital gain rates and other tax increases. The capital gain tax recently rose 15 to 20 percent and there is now a healthcare tax of nearly 4 percent on certain gains.

Tax-Deferred Does Not Equal Tax-Free

Keep in mind, tax-deferred and tax-free are not the same thing. If and when you sell, your tax liability is still there, in full force. It’s something you have to keep in the back of your mind when setting your long-term investment goals.

Tips to Help the Process Go Smoothly

Most investors understand that, in a like-kind exchange, they are unable to touch the money and need to locate and begin the purchase process for a the replacement property within 45 days of the closing date of the property being sold.

These two things are true but there are other things you need to get in place ahead of time to guarantee a smooth 1031 exchange. For instance:

Complete the Exchange Documents Prior to Closing

Make sure the exchange documents are signed prior to or on the date of the closing of the sale of the property being relinquished.

Consider Who Will Purchase the Replacement Property

This is important if you are operating an LLC. Remember, the person selling the property must be the same one buying the property to enjoy the tax benefits.

Make Sure You’re Able to Defer All of the Gain

Two things are required in a 1031 exchange to defer all of the tax:

  • The replacement property must be worth the same amount or more than the relinquished property. For example, if you sell something for $1 million, you have to buy a property worth at least $1 million or the deal could be taxed, at least in part.
  • You must invest the total net equity from the sale into the purchase of the new property. For example, if you sell something for $1 million and there’s a $300,000 loan on it, the $700,000 netted from the sale must be rolled into the new property.

Consider the Expenses

Some expenses can be paid with the exchange proceeds without triggering a tax. These include commissions, fees held in escrow, exchange fees, and taxes related to the transfer.

If you sell a property you intend to use in a 1031 exchange, though, you won’t be able to give the buyer a credit because this equates to exchanging proceeds for non-exchange expenses. This can result in your exchange being partially taxable so it’s best to come in with your own funds if you want to offer these incentives.

Consider Safety

A third-party intermediary holds funds until it’s time to reinvest in the replacement properties when you do a 1031 exchange. Make sure you understand how those funds are held and that you are working with a financially strong and reputable intermediary.

The execution of a 1031 exchange is best done under the guidance of an experienced professional. It’s too easy for an investor to get tripped up on the complex rules and regulations the Internal Revenue Service has in place.

Finding a knowledgeable professional is critical for accurately assessing is better for your investment goals. They can also help you find a suitable replacement property within the limited time frame to appropriately reinvest the proceeds from the sale.

We have experience working with clients on 1031 exchanges and can help you with your 1031 exchange documents. We’re here to answer all of your questions and do what we can to make sure the transaction goes smoothly so you can enjoy the benefits that come with a 1031 exchange. To learn more or to begin your 1031 exchange, sign up for our newsletter.

About the author 

Eric Bowlin

Eric is an investor that achieved financial independence at the age of 30. He started in 2009 with the purchase of his first triplex and now owns over 470 rental units. He spends his time with his family, growing his businesses, diversifying his income, and teaching others how to achieve financial independence through real estate. Eric has been seen on Forbes, Trulia, WiseBread, TheStreet, Yahoo Finance and other financial publications. You can contact Eric by emailing him at [email protected] or with this contact form

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