Real Estate Investing 101: What is a 1031 Exchange?

Tax savings when selling and buying real estate investments

Congrats! You own real estate and you’re doing well enough that you are ready to sell a property to upgrade into a larger or more profitable asset. But how do you do that without losing all your money to taxes? Worry no more. A 1031 exchange, based on the IRS code, allows you to sell your investment property, reinvest the proceeds in a same or bigger property, and defer paying taxes on that sale. The 1031 exchange provides many benefits to investors including tax deferral, diversification, tax-advantaged cash flow and wealth preservation. 

**Disclaimer: I am not a tax professional nor an attorney so this advice is purely a starting point to understand the steps. While I can help you with the buying and selling of real estate, consulting and hiring a professional to handle the financial transaction through an intermediary Is essential. 

The Steps and Timing of Using a 1031 Exchange

To successfully complete a 1031 Exchange and defer your capital gains liability, you must follow very specific requirements over a strict 180-day timeline.

  1. Hire a Qualified Intermediary (QI) to hold your funds between selling and buying BEFORE you sell your property. Do this essential work first, before you start any other process. A qualified intermediary will receive the net proceeds out of escrow and hold the money until escrow is opened up on the replacement property.  Any money that comes to you directly and does not go from the closing of the relinquished to the intermediary to the escrow of the replacement property will trigger a taxable event.

  2. Sell your property; proceeds are escrowed with your Qualified Intermediary

  3. Identify a property within 45 days that is “like-kind”, either same or better, regardless of differences in grade, property type or quality. Future property must also carry the same amount of debt as the original property. 

  4. Close on your new property within 180 days of the sale of the first property

Additional Rules

  • The new property you purchase MUST be of equal or greater value than the property you sold. You cannot downsize. For example if you’re selling the home for $500k and there is a $300k mortgage then the replacement property needs to be purchased for at least $500k with at least $300k of debt.  If the replacement property has a lower purchase price or you use less debt to acquire it you end up with what is called “boot”.  The ordering of gain recognition in a 1031 exchange forces you to treat boot as 100% gain, so having boot left in a 1031 limits the tax benefit of a 1031 exchange. 

  • You MUST reinvest all the equity - you can’t keep some and spend some

  • You MUST take on equal or greater amounts of debt on the new property. You cannot pay cash for it with no mortgage payment. In other words, the equity you have in the first property - including the loan - has to then be met or exceeded by the equity plus loan in the new property

  • The sale of the first property and the purchase of the new property must all be in the same name - individual or LLC. Securing debt in the name of an entity can also take a bit longer than in the name of an individual so you’ll want to make sure the lender is clear on how the mortgage will need to be underwritten as well.  

The rules on 1031 exchanges are strict but the benefits are great so make sure you are following each step exactly according to IRS code so that you have the best tax benefits for your portfolio. 

Another Option

In addition, instead of buying your own investment property following the rules above, you could sell your property and then invest that profit into a Delaware Statutory Trust (DST) using the 1031 Exchange and achieving the same tax benefits. Much like a REIT, a DST is a trust that allows investors to own real estate in a passive manner. No more toilets to fix! Typically a 5-7 year investment and a single asset, investors receive income derived from rents, tax efficiency from depreciation and other expenses, and the ability to perform another 1031 exchange once the asset is sold.

Let’s Get to Work

Investing in real estate should be fun (and profitable). Let me help you run the numbers and figure out what best works for your investment vision.