If you’re a real estate investor, the 1031 exchange—which gets its name from Section 1031 of the U.S. Internal Revenue Code—is your best friend!
Why? Because for about 100 years, the 1031 exchange has allowed real estate investors the chance to reinvest the profits from the sale of a property without having to pay capital gains tax. As long as you replace one investment property with another and follow all the rules set by Uncle Sam (we’ll get to all of those in a minute), you can keep kicking that tax bill down the road.
But how exactly does this century-old tax loophole work? Let’s dive right into it!
What Is a 1031 Exchange?
Basically, a 1031 exchange allows you to avoid paying capital gains tax when you sell an investment real estate property if you reinvest your profits into another similar property within a certain period of time.
So let’s say you bought a real estate property five years ago. During that time, the property’s value went way, way up and you sold it this year for a $300,000 profit (after any commissions or closing costs paid). Not too shabby!
If your long-term capital gains tax rate is 20%, that means you’d owe $60,000 on the sale of that property. Boo! Thanks to the 1031 exchange, you can reinvest the profits into another investment property (that costs the same or greater than the property you just sold) and avoid paying those taxes altogether.
Just a side note: 1031 exchanges do not apply to primary residences. However, you could swap a former primary residence or vacation home under very specific conditions.
For example, let’s say you have a lake house that you decided to turn into a rental property. You’ve had a tenant living there for the past year, but now you want to sell it and buy another rental property. Would that qualify for a 1031 exchange? As long as you can show the IRS that you’ve been using the property for business purposes, you shouldn’t have any problems!
How to Do a 1031 Exchange
Listen up! There are certain rules you need to follow down to the letter and deadlines to meet on time in order for a swap of properties to qualify as a 1031 exchange. If you’re not careful, it could lead to a nasty Tax Day surprise . . . and trust us, you don’t want that to happen!
When you boil it all down, here are the five basic steps to completing a 1031 exchange.
1. Choose a qualified intermediary to coordinate the exchange.
Because any money you receive from selling a property is taxable, you technically can’t receive that money when you sell your property. If you do wind up taking control of the cash at any time before the exchange is complete, it could disqualify the entire transaction and you’ll owe taxes on all of your capital gains.
That’s why you need a qualified intermediary to help with the exchange (you’re not allowed to do it yourself). This person will act as a middleman for the 1031 exchange and they will hold on to the proceeds from the sale of your property while you look for a new one.
2. Sell your current real estate property.
One you have a qualified intermediary in place, then you can sell your investment property. But fair warning: You only have a small window of time to identify and eventually close on a replacement property. Once you sell your investment property, the clock starts ticking . . . so get moving!
3. You have 45 days to identify potential replacement properties.
Next, you have to come up with a small list of possible properties you plan to buy to replace the one you just sold. Don’t wait too long, though. You have just 45 days from the day you sell your property to identify potential replacement properties.1 And there are no extensions to this deadline!
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Once you’ve identified the potential properties, the identification has to be made in writing and signed by you. Then you’ll need to deliver that identification to someone involved in the exchange—that could be the seller of the replacement property or your qualified intermediary.2
4. You have 180 days to close on a replacement property.
Here’s the fun part! Once you’ve found a property you like, you’ll use the funds from the sale of your other investment property to purchase your new property. Touchdown, baby! But remember: You have just 180 days (that’s roughly six months’ time) from the day you sell your property to close on your replacement property.3
5. File IRS Form 8824.
Once you’re done celebrating your new property, it’s time to fill out some paperwork (we know . . . so much fun!). You will need to fill out Form 8824, which is used to report like-kind exchanges of business or investment properties.
Since 1031 exchanges can get really complicated really quickly, working with a qualified tax advisor who can help you get all the details right can take a lot of the stress out of the process.
Choosing a Replacement Property for a 1031 Exchange
When you do a 1031 exchange, the swap has to be between what the IRS calls “like-kind” properties. Basically, that just means that both properties—the one being sold and the one being purchased—must be used for business or investment purposes.
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What kind of property (or properties) meet the IRS requirements for a 1031 exchange? Here are a few important guidelines to follow when you choose a replacement property:
Properties don’t need to be the same type.
For example, you can exchange raw land for a rental house, or an office building for an apartment complex. As long as they are being used for business or investment purposes, you’ve got the green light.
Properties can be located anywhere in the U.S.
Maybe you’re moving to Florida and you want to sell a property you own in New York so you can purchase one in the Sunshine State. That’s not a problem—in fact, you can exchange like-kind properties from anywhere in the U.S. of A.!
An exchange can include multiple properties.
Do you want to sell one property and use the profits to buy three different properties? As long as they’re all used for business or investment purposes, there’s no problem there.
The replacement property (or properties) must be of equal or greater value than the one being sold.
If you want to defer all of your capital gains taxes, the replacement property you buy has to have a purchase price that is equal to or greater than the property you sold. If the replacement property is worth less than the one you sold, you’ll have to pay taxes on the difference.
Need help finding replacement properties? A top-notch real estate agent in your area can help you find those properties and close on them within those deadlines you need to meet.
What Is a Qualified Intermediary?
Like we talked about earlier, if you want to defer the capital gains taxes you owe, you’re not allowed to receive the proceeds of the sale directly. That’s where a qualified intermediary comes in.
This qualified intermediary will sell the property on your behalf and receive the proceeds from the sale for you. They will keep those funds in an escrow account with their financial institution until you’re ready to buy the replacement property.
Once the purchase is complete, they’ll transfer the deed over to you . . . and that’s it! If there are any proceeds left over from the exchange, the qualified intermediary will return those funds to you.
Who Can Be a Qualified Intermediary?
So, who can be a qualified intermediary? Here are some examples of professionals who probably have the ability to act as a qualified intermediary during a 1031 exchange:
- Real estate agents
- Investment professionals
- Certified Public Accountants (CPAs)
Unfortunately, you cannot be your own intermediary and you can’t pick someone who is related to you (sorry, Uncle Bob) or who has acted as your agent in the past two years.
How Do I Find a Qualified Intermediary?
Don’t know where to look for a qualified intermediary? You can start by talking to a real estate or tax Endorsed Local Provider about the possibility of acting as a qualified intermediary on your behalf.
There are also plenty of companies and organizations out there that can connect you with a qualified intermediary and other 1031 exchange services. The Federation of Exchange Accommodators (FEA) has a qualified intermediary certification program with a directory of its members you can reach out to.4
Are Changes to the 1031 Exchange Coming?
Right now, there’s no limit on the amount of capital gains from the sale of investment real estate properties that can be protected from taxes using 1031 exchanges. It’s been that way for 100 years . . . but there’s a chance that might change soon.
While President Biden doesn’t want to eliminate 1031 exchanges completely, he does want to put some limits on how they are used.
Here’s what you need to know: The Biden administration’s budget that was released in May has a proposal to limit the amount of capital gains from investment property sales that can be deferred each year. Under the proposal, individuals would be allowed to defer $500,000 worth of capital gains per year while married couples could defer $1 million per year.5
The administration argues that these exchanges mostly benefit the wealthy and that these limits will raise tax revenues to fund programs designed to help the middle class. But opponents argue that 1031 exchanges benefit the real estate market and the national economy by encouraging investment into communities while helping property owners from a wide range of incomes build wealth.6
Before you panic and start selling off all your properties faster than an auctioneer who had one-too-many energy drinks this morning, remember that nothing is set in stone. This is still just a proposal. The budget still has to pass through a divided Congress and there will be lots of back-and-forth as the politicians in Washington debate over this proposal.
Work With Pros You Can Trust
There are lots of rules and guidelines you need to follow in order for a swap of properties to qualify as a 1031 exchange. And one misstep could unravel the whole process, leaving you with a massive tax bill. That’s why if you’re considering making a 1031 exchange, you should always work with professionals you can trust to walk you through the process.
The good news is our Endorsed Local Providers (ELP) program can connect you with qualified tax pros and the best real estate agents in your area. With their help, you can rest easy knowing that your exchange is in the hands of professionals you can trust!
This article provides general guidelines about investing topics. Your situation may be unique. If you have questions, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.