What Is a 1031 Exchange? Minimizing the Tax Bill On Your Real Estate Investment

What if I said you could pay little to no taxes on your property sale? Sounds too good to be true, but it’s not.

What is a 1031 exchange?

But the key word here is defer. Once you sell off your investment properties for cash, you will have to pay the capital-gains taxes you owe up to that point. However, as long as you continue rolling profits into new like-kind properties, you can keep taxes at bay. Stick around until the end, and you’ll see a clever way to eliminate those pesky taxes for good.

So, 1031 exchanges sound great, right? Not so fast. The IRS isn’t just going to let you keep all that money without a fight, so they structured 1031 exchanges around a bunch of rules and procedures.

How do 1031 exchanges work and does my property qualify?

There are several types of 1031 exchanges, including delayed exchanges, built-to-suit exchanges and reverse exchanges. Each comes with its own set of requirements. For the sake of brevity, we’ll outline the delayed exchange, which is the most common.

The delayed 1031 exchange consists of four main steps:

1. Complete the sale of your Relinquished Property.
2. Send the proceeds to a Qualified Intermediary.
3. Identify a Replacement Property to buy within 45 days.
4. Have the Qualified Intermediary transfer the money and finalize the purchase within 180 days.

Who is a Qualified Intermediary?

Since the proceeds from your Relinquished Property sale are still taxable, you’re required to transfer the money to a Qualified Intermediary (QI). This middle-man safeguards the funds and transfers them to the seller once you’re ready to pull the trigger on the Replacement Property.

What qualifies as a Replacement Property?

Both properties must be located in the United States. You cannot, for example, trade a U.S. property for a Puerto Rican property under a 1031 exchange.

Deadlines

There are two IRS-mandated deadlines, both starting the second you finalize the sale of your Relinquished Property:

• You must designate the Replacement Property in writing to the QI within 45 days.
• You must close on the Replacement Property within 180 days.

Property type

The Replacement Property has to be of “like-kind” to your Relinquished Property, but the definition is broad. You could exchange an office building for farmland, for example. The property must be:

• An investment property, not a personal residence.
• Approximately equal to or greater than the value of your Relinquished Property.

Identification limits

The IRS also limits how many properties you can identify:

• 3 Property Rule: Identify and buy up to three properties, regardless of value.
• 200% Rule: Identify more than three properties as long as their total value does not exceed 200% of the Relinquished Property’s value.
• 95% Rule: Identify more than three properties whose total value exceeds 200%, provided you purchase at least 95% of the properties identified.

Pros and cons of doing a 1031 exchange

A 1031 exchange is a great way to defer capital-gains taxes—if you follow all the IRS rules to a T. Let’s weigh the pros and cons so you can decide whether a 1031 exchange makes sense for you.

Pros of a 1031 Exchange

Tax deferral

When you sell a property, pay taxes, and then buy another property, you lower your purchasing power. By utilizing a 1031 exchange, you roll your gains over into the next property, allowing you to build a more valuable real-estate portfolio faster.

Favorable tax rate

You can do an unlimited number of 1031 exchanges. When you finally do cash out, gains are taxed at the long-term capital-gains rate—capped at 20% and often no higher than 15% for most investors.

Zero taxes owed

You can take deferred gains to the grave. Upon your death, all deferred taxes are erased and your heirs inherit the property at current market value—an efficient way to build generational wealth.

Cons of a 1031 Exchange

Strict rules

Miss a single deadline or requirement and the IRS can disqualify your swap, saddling you with the full capital-gains tax bill. Planning ahead—and having backup properties—is critical.

Extra costs

Real-estate transaction costs are already high. You’ll also need to hire a Qualified Intermediary, which can cost up to $1,250.

Unexpected taxes

Any money left over at the end of a 1031 exchange is called cash boot, and it’s taxable. The boot also applies to loans: if the mortgage on the Replacement Property ($700K) is lower than the mortgage on the Relinquished Property ($800K), the $100K difference is taxable.

Should I do a 1031 exchange?

When used properly, a 1031 exchange can be an effective tax-deferral strategy that helps you build wealth. But it isn’t right for everyone.

• The investment property you plan to purchase must qualify. A 1031 requires at least a two-year holding period, so it’s not ideal if you may need cash soon.
• If you don’t incur capital gains after deducting losses, using a 1031 offers no benefit.
• If you’re in a low tax bracket now but expect to move up, it may be smarter to pay taxes today rather than defer them.
• High-net-worth individuals often benefit the most from deferring gains via a 1031 exchange.