How to Use 1031 Exchanges to Invest in Real Estate

Do you own an investment property that is worth more than you paid for it? If so, you will have to pay capital gains tax upon the sale of the property. But with a 1031 exchange, you may be able to swap one investment for another to defer the payment of any capital gains taxes.



What is a 1031 Exchange?


Under Section 1031 of the United States Internal Revenue Code, a taxpayer may defer 100% of capital gains and related federal income tax liability on the exchange of certain types of property. A 1031 exchange can be a useful tool for swapping investment properties, deferring taxes and building wealth through real estate, but there are certain rules and limitations that investors must be aware of.


Rules and Limitations of a 1031 Exchange


First, a 1031 exchange can only be used for properties that are held for business or investment purposes. This means that you cannot use it for the sale of your primary residence.


Second, to qualify, most exchanges must be of like-kind, but the rules on this are surprisingly liberal. You can exchange an apartment building for raw land or a ranch for a strip mall so long as both properties are used for investment purposes.


Third, the market value of the replacement property must be the same as or greater than the relinquished property and both purchases must be under the same taxpayer name.


Types of 1031 Exchanges


There are four different types of 1031 exchanges and each comes with its own set of rules.


Simultaneous Exchange. In an immediate or simultaneous exchange, the sale of the existing property and purchase of the new property are completed on the same day. There are three different types of simultaneous exchanges:


  1. Swap or Two-Party Trade: This is the most basic 1031 exchange where two parties swap deeds with each other and there is typically no need for a qualified intermediary (QI), a professional who holds the cash after the sale and uses it for the purchase of the replacement property.

  2. Three-Party Trade: The primary difference with this type of exchange and a two-party exchange is that only one of the parties wishes to do an exchange and the second party has no property to transfer to the taxpayer/exchanger. However, the parties arrange so a third-party seller of a target property is identified. The second party buyer acquires the target property from the third party and exchanges that property with the taxpayer to enable the taxpayer to complete their exchange. This type of transaction also closes simultaneously.

  3. Simultaneous with a Qualified Intermediary: Taxpayers doing a two-party simultaneous exchange do not necessarily need to use a QI provided that the contracts are prepared properly; however, many choose to use a QI to provide written instructions to the closing officers and prepare the exchange agreement and other documents in order to ensure that they are abiding by the regulations. In addition, this format can be easily converted to a delayed exchange which eliminates the time pressure of trying to close the entire transaction simultaneously.


Deferred Exchange. The most common type of 1031 transaction is a deferred exchange, where an investor has 180 days to close on another purchase after the sale of the relinquished property. Within 45 days of the sale, you must designate a replacement property. You can designate three properties as long as you eventually close on one of them. This type of exchange requires the use of a QI who holds the proceeds of the sale until the purchase of the replacement property. Unlike the prior types of exchanges, the sale of the old property and the acquisition of the new property are not simultaneous.


Reverse Exchange. Under the regulations, exchanges must be completed in the proper sequence. This means the sale of the relinquished property must take place prior to the acquisition of the replacement property. A reverse exchange can be used in scenarios where the taxpayer must acquire the new property prior to the sale of the relinquished property, but this type of transaction is much more complicated than a standard forward transaction.


Construction-to-Suit or Improvement Exchange. This type of exchange allows a taxpayer to use any excess sale proceeds to improve the acquired replacement property as part of the 1031 Exchange transaction.The proceeds from the sale of the relinquished property that are used toward the acquisition of the replacement property as well as those proceeds that are paid or used for improvements to the replacement property will qualify for tax-deferred exchange treatment provided the transaction is structured properly as a Build-To-Suit Exchange. This is a complicated transaction which requires the use of a QI.



Things to Consider


Timing is essential for a 1031 exchange. Especially with a deferred exchange and in a market with limited inventory or high competition, it might be best practice to identify the replacement property before the sale of the relinquished property. In addition, it’s important to find a replacement property that is equal to or greater than the relinquished property, as any proceeds from the sale are subject to capital gains. A note to remember: a 1031 exchange acts as a deferral of the capital gains tax, and not a forgiveness, so any capital gains tax would be due once you have stopped reinvesting the proceeds from the sale.



As you can see, there are a lot of different rules and regulations to follow, so if you are interested in pursuing a 1031 exchange, we can put you in contact with the right professionals to provide you with advice and direction.