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What Landlords Needs to Know About 1031 Exchanges

Quick Takeaways

  • A 1031 exchange is a swap of properties that are held for business or investment purposes.
  • The properties being exchanged must be considered like-kind in the eyes of the IRS for capital gains taxes to be deferred.
  • If used correctly, there is no limit on how many times or how frequently you can do 1031 exchanges. However, running frequent exchanges or holding properties for only short periods might make the IRS question your intent.
  • The rules can apply to a former primary or secondary residence under very specific conditions.
  • Visit the IRS website for more info.

What is a 1031 exchange?

Broadly defined, a 1031 exchange is a swap of like-kind properties eg. one investment property for another. We explore in more detail what like-kind means further down the article.

If you meet the requirements of 1031, you’ll either have no tax or limited tax due at the time of the exchange.

Essentially, a 1031 allows you to change the form of your investment without cashing out and being subjected to capital gains taxes. In this way you can defer capital gains on your property. There are no limits to how many times or how frequently you can do a 1031 exchange instead you could roll over the exchange from one property to another, and then another.

When you do eventually sell though you will have to pay capital gain tax which will be at the long term capital gains rates (currently around 15 – 20%).

The 1031 provision is for investment and business properties, however, the rules can apply to a primary residence under particular conditions and you can also use a 1031 exchange for swapping out a vacation home – again if you meet particular criteria.

houses

Special rules for depreciated property

When a depreciable property is exchanged it can trigger the depreciation recapture process. In short the depreciated amount used in tax deductions is then taxable as ordinary income rates.

In general if it’s a direct swap of one property for another you can avoid the depreciation recapture, but there are scenarios where it might be applicable.

There are numerous such complications and nuances in the exchange process which is why it’s so important to get qualified professional help when you’re doing a 1031 exchange.

What is a reverse 1031 exchange?

A reverse 1031 exchange is when you locate a property that you’d like to acquire before you find a buyer for your own property. Instead of waiting till you close on your relinquished property you can make an offer.

In this situation it’s common practice to make the purchase contingent on whether your property actually sells. If you close on the property you are selling before you close on the one you are purchasing the exchange works normally and is considered a delayed exchange.

If however, you decide you must close before you have a buyer in place for your relinquished property you can acquire it using a reverse exchange. Generally, this process is a little more expensive, however, it’s still fairly common as the buyer get’s assurance that they will get the exact property they want, while still being able to defer capital gains tax when they sell their property in the future.

What do they mean by like-kind of property for a 1031 exchange?

The term like-kind is a bit disingenuous in this context. It does not mean, as you might assume, a Single Family Home (SFH) must be exchanged for a SFH. Like-kind instead refers to the nature of the investment rather than the form. In this regard, it means any type of investment property can be exchanged for any type of investment property.

For example, a SFH can be exchanged for a triplex or duplex, raw land or even a commercial rental property. In fact, as the exchanger you could swap one high value property for multiple small value properties even. Because of this there is quite a bit of flexibility to run 1031 exchanges to develop your investment strategy.

You cannot however, swap a different asset type, eg. a primary residence for an investment property. Nor can you trade partnership shares, bonds, certificates of trust or other such items. Additionally, developments or refurbished and flipped properties are considered stock in trade and are not exchangeable either.

apartment exchange 1031

How to determine if your property qualifies for a 1031 exchange?

There are a few specific criteria that you must meet in order to qualify for a 1031 exchange.

  • Both properties must be located in the U.S.
  • The properties must be like-kind. You can however, turn a primary or secondary residence into a rental property as long as the property meets the like-kind requirement at the time of the 1031 exchange.
  • You must not be deemed a dealer by the IRS eg. one of your primary sources of income is through selling properties.

You can exchange across state borders, this is actually very common. It is important though to note that there are variations in the treatment of taxes and local fees associated with each state so it’s a good idea to read up around those laws and regulations as part of the decision-making process before completing your exchange so that you don’t get caught out.

About the time requirements for a 1031 exchange

A classic exchange involves a simple swap of one property for another between two people. However, the chances of finding a person who has the exact property you want when you have the exact property they want is pretty slim. Because of this, the majority or exchanges are third-party, delayed, or Starker exchanges.

In a delayed exchange you will need to find a qualified intermediary or middleman to hold the cash after you sell your property. You will then use that cash to “buy” the replacement. A three party exchange is treated as a swap but with more than two parties involved.

There are two key times during the 1031 exchange process that you need to be aware of.

The 45 day rule.

After 45 days of the sale of your property you must inform the intermediary of the property that  you want to acquire. The IRS says you can designate up to three properties as long as you close on at least one. You can designate more than three properties if they meet particular valuation requirements. For example, you are swapping one high value property for multiple small value properties.

The 180 day rule

The second important timing requirement to note is 180 days. In a deferred exchange you need to close on the new property within 180 days of selling your old property.

It’s important to note that the two time periods work in conjunction. Meaning you have 45 days to find the property you want , and a further 135 days to close.

1031 exchange

How to get started with a 1031 exchange

Find a facilitator

Getting started with an exchanges starts with finding a good facilitator. Because of the complications that can arise during an exchange it’s important to find an experienced and qualified professional to help you navigate the process and handle legal complications.

You can obtain the names of facilitators from the internet, attorneys, CPAs, escrow companies or real estate agents. Exchange fees typically range from $400 to $750. You may wish to obtain copies of the documents the facilitator will use for review by your attorney.

Gather all the relevant information

You should have all the salient information ready to share with your facilitator. Not doing so will delay the process.

Typically the key information you need to structure an exchange is: The Exchangor’s name, address and phone number and the escrow officer’s name, address, phone number and escrow number.

However, having the following additional available so that the facilitator can properly review the exchange is a good idea:

  • The property being exchanged
  • Dates when the property was acquired
  • How much the property cost when it was acquired.
  • How has the property been used during your ownership?
  • Have you already organised a sale?
  • How much equity and mortgage is in the property?

And if you have them ready these details as well:

  • What property would you like to acquire?
  • What would the purchase price be?
  • Details on equity and mortgage.

The Bottom Line

In general, a 1031 exchange is a great way to defer capital gains taxes meaning you have more cash right now to build wealth. There are a few additional important things to consider and further nuances to the aspects we have touched on in this article. Such as, if you want to use the property that you swap for as your primary residence you can’t do so immediately. To meet the safe harbor requirements in the period immediately after the exchange: 

  • You must rent the dwelling unit to another person for a fair rental for 14 days or more.
  • Your own personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

Their are many complex parts of a 1031 exchange so it’s important that even seasoned investors enlist proper professional help to make sure the exchange is pulled off smoothly.

This article is meant for information purposes only and nothing written here as legal or professional advice. If you are considering a 1031 exchange please contact a licenced professional.

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Ben Luxon

"Ben is an author and real estate enthusiast. His interest in all things entrepreneurial has led him to work with real estate professionals all over the world, distilling their knowledge into articles and Ebooks. His love of travelling has taken him to over 10 countries in the last year, where he has sampled the craft beer of them all."

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