Last updated on December 5th, 2019 at 07:50 pm
The rules for a 1031 exchange (also called Like-Kind or Starker exchange) can seem complicated and a little bit scary. This guide walks through the requirements, rules, options, and various examples. You’ll know why real estate investors love the tax benefits of a 1031 exchange!
What is a 1031 Exchange?
The 1031 Exchange was established to allow real estate investors a deferral on taxes when a property is sold. Instead of assessing taxes each time an investor sells a property, you are able to “roll over” the gains. It’s also called a “like-kind” exchange because the “relinquished” property must be the same type as the “replacement” property. The value of each property must also be similar.
The idea behind the 1031 is when an individual sells a rental to buy another one, there is no gain. There has only been a transfer from one property to another. For example, if a real estate investor sells a warehouse to buy another one, she won’t owe taxes on the old warehouse. When the investor sells the old warehouse and buys a new one, the value used from the old to buy the new one hasn’t changed. The only change is which property stores the investors’ value.
Why do a 1031 Exchange?
The 1031 like-kind exchange is best for real estate investors with properties that have greatly appreciated in value. There are a handful of reasons investors do a 1031 exchange:
- Save on Taxes – You can defer federal and state capital gains tax, as well as depreciation recapture tax. Instead of paying tax upon each sale, you continue to defer tax, enjoying its cash flows.
- Higher Returns – If you own a property outright, you can use the proceeds from sale as a down payment on a more valuable property. This can increase your effective cash flow and net worth immediately.
- Estate Planning – If an investor dies while they own a 1031 exchange property, the heirs receive the property at a “step-up” basis. This means their cost-basis is equal to the fair market value at death, and taxes are minimal. This is a tremendous advantage for heirs compared to immediately selling a property.
- Consolidation – Most real estate investors begin with single family homes spread across different neighborhoods, cities, or states. The maintenance, upkeep, and monitoring of these far-flung properties can be tiring. Some investors will consolidate multiple SFH’s into a single apartment complex or commercial property, reducing their work required.
- Diversification – Many investors in high cost of living areas such as California will sell a single, valuable property and buy multiple properties in multiple areas. This reduces risk if the area experiences a downturn in property values. This also works for investors who want to sell single family homes and invest in a single warehouse or NNN property.
- Read more about 1031 exchanges with multiple properties
4 Types of 1031 Exchanges
There are four types of 1031 or like-kind exchanges investors can use for their situation. These include the construction or improvement exchange, simultaneous, delayed, and reverse exchanges.
Owing to our name, we’ll give you the inside scoop on each type of 1031 exchange. You’ll walk away from this portion of the article knowing which is the most popular, the least, and when to use which type for your scenario.
This is the oldest and most uncommon type of 1031 exchange. If you’re able to find the right kind of replacement property, it can also be the easiest to do.
A simultaneous exchange occurs when you find an exact property to exchange for your own property. The properties are exchanged on the same day, and as the name suggests, the same time. Any delay, even a bank wire or escrow issue, would result in the exchange being nullified.
There are three main types of simultaneous exchange:
- Two-party trade, when the two parties trade or “exchange” deeds
- Three-party exchange, when an “accommodating party” “holds title” so the transaction is facilitated in a simultaneous way
- Simultaneous exchange with the assistance of a qualified intermediary who conducts the entire exchange
By far the most common type of exchange, also known as the “forward exchange.” When people refer to the 1031 exchange in general, this is usually the exchange they are referring to.
The forward exchange occurs when you sell an existing investment or business property, then acquire a replacement property within 180 days. Said differently, the first step is selling your existing property. The second is signing up with a qualified intermediary. The third identifying potential replacement properties, and the fourth closing on one of those properties.
Still confused? Check out our infographic below. We do recommend engaging with a qualified intermediary before the sale of your existing property closes.
A large source of confusion can come from the identification period. To make it simple, in a forward exchange, the exchange begins when the existing property sale closes. From this day until day 45, you must identify up to three suitable replacement properties. Then, you must close on one of the properties you’ve identified. Note that if the replacement property isn’t worth as much as the old property, you’ll have what’s called “boot.”
This is a big reason why it’s essential to work with a qualified intermediary. They’ll hold the proceeds of your existing property sale, help you document identified properties, and help complete the exchange. Still need help? We wrote in-depth about the delayed 1031 exchange.
The reverse exchange, also known as a forward exchange, is the same as the delayed exchange but in reverse. They occur when you purchase a replacement property as your first step, then identify and sell a property you already own. The major advantage is that you can focus your time on what’s usually the hardest part of the exchange – finding a great replacement property.
In theory, the reverse exchange is easier to pull off than a regular exchange. In practice, it can be difficult because of funding. Reverse exchanges are tricky because they require an all-cash transaction. You can’t use the proceeds from selling your existing property because you’re buying the replacement first.
Also, many banks and traditional lenders won’t offer loans for these transactions. The other risk is that instead of buying the replacement within 180 days, you need to sell the existing property within 180 days. If your buyer hits any kind of snag that’s out of your control, your exchange could fail.
If you’re confused about the timeline and sequence of events for a reverse 1031 exchange, we made this helpful infographic. A qualified intermediary for a reverse exchange is absolutely necessary.\
One of the least known but fastest growing types of exchange is the construction exchange. Also called the improvement or build-to-suit exchange, it allows you to make improvements to your replacement property during the 180-day window.
For example, let’s assume you sell an existing property for $400,000. Then you purchase a $250,000 property and add $150,000 of tax free improvements. Investors use the construction exchange as it offers more flexibility than a typical delayed or reverse exchange. You can buy replacement properties that are the same value or higher without worrying about boot. Also, you can buy low priced properties or vacant land and build a building on it.
You do need to meet three main requirements or rules to do an improvement exchange. These are:
- The equity from your previous property must be spent on completed improvements or the down payment by day 180
- You must receive “substantially the same property” on day 180 as what you identified by the 45th day. This means you cannot submit blueprints to add a pool to an apartment complex, and then build a gym instead
- The replacement property has to be equal or greater value when you take deed again. The improvements cannot be “ordered materials” they have to be installed onto the property
There are many scenarios where a construction exchange makes sense, but they are complex. We highly recommend consulting an accountant or lawyer to help plan the exchange. Then, use a local qualified intermediary to conduct the exchange. There are many aspects of the construction exchange that need to be seen in person.
1031 Exchange Rules – The 7 You Should Know
It can feel a bit overwhelming when you first start thinking about a 1031 exchange. Certain scenarios are good for an exchange, and others aren’t. We’ve tried to simplify the 1031 as much as possible, and these are the top 7 rules to keep in mind.
Rule #1: Replacement Property Must Be “Like-Kind”
This can get confusing for 1031 exchange newbies, but it’s easy in practice. In order to qualify for a 1031 exchange, the old property must be the same type as the new, replacement property. Some assume this means that the two properties need to both be a duplex, or a condo, which is NOT the case.
By the IRS’ standard, virtually any two types of real estate are “like-kind” to each other. A triplex is like kind to vacant land, and a condo is like kind to a farm. As long as the exchange is not personal property or outside the United States, it is usually like-kind.
Also, a Starker or 1031 exchange can also include multiple properties. If you live in a high priced area such as California, it can make sense to diversify. By selling one expensive property and buying multiple properties in a cheaper area, you reduce risk and increase cashflow.
Rule #2: For Productive Use in a Trade or Business
The IRS directly says that in order for a property to qualify for a 1031, it must be for “productive use in a trade or business.” This is a lawyer-like way of saying that the property can’t be your home or a personal asset. There are some scenarios where you can exchange your primary residence, but tons of restrictions apply.
Rule #3: New Property Must Be Equal or Higher in Value
In order to defer any type of taxes from the sale, the new property must be equal or greater in value to the replacement. If the new property is less in value than the old one, that results in “boot” and is taxable. We’ll cover “boot” in our next rule.
To illustrate the third rule, let’s say you have a property worth $1M and a mortgage for $250,000. In order to defer all taxes, your new property must have a $1M value and carry over at least $250,000 of the mortgage. Additionally, all closing costs such as inspection fees and broker fees will apply to the value of the new property.
Rule #4: Cannot Receive “Boot”
If your new property is less valuable than the equity in your old one, you will have “boot.” This boot is the portion of the 1031 exchange that is taxable. Since the only purpose of a 1031 exchange is to defer taxes, it’s safe to say boot is not a good thing.
If you do end up having “boot” this is called a partial 1031 exchange.
For example, say you sell a property for $1M. If your replacement property is only $700,000, you’ll pay capital gains tax on the $300,000 difference. If you’re in a negotiation, it’s still better to pay less for the property and take a hit at your tax rate!
Rule #5: Same Exchangor
In order to complete a 1031 exchange successfully, the same person must sell the old property and buy the new one. This may seem obvious, but since many properties are held in LLC’s it can be a point of confusion. The IRS needs a way to know that people are not exchanging properties and someone else buying them.
The exception to this rule comes from single-member LLC’s. For example, say Robert Smith owns a property in a single-member LLC. He then purchases a replacement in his actual name, which is allowed.
Rule #6: The 45-Day Identification Period
Known as the most difficult stretch during a 1031 exchange, the 45-day identification period keeps investors up at night. It can sound confusing at first, but it’s really simple: After you sell your old property, you must identify up to three potential replacements within 45 days. Or, you can identify four or more replacement properties, but their combined value cannot exceed 200% of the property sale price.
The reason this period stresses investors out is because finding a suitable, cash-flowing property is hard work. Every market is different, and some markets simply don’t have properties that will cash flow from day one.
One way investors are getting around the 45-day identification period is with a reverse exchange. This is the same as a forward or delayed exchange, but in reverse. Instead of scrambling to identify replacement properties after a sale, you do that work up front. Then, after you’ve purchased the replacement property, you have 45 days to identify a property you already own to sell. See why it would be a lot easier?
Reverse 1031 exchanges are not easy, and a capable qualified intermediary is 100% necessary.
Rule #7: The 180-Day Purchase Period
The last step in a forward exchange is to actually purchase the replacement property. This must be done within 180 days of the exchange beginning. In a forward exchange, it begins when you sell your old property. Yes, the new property must be one of the properties you identified during the 45-day period.
1031 Exchange Rules – Conclusion
As you can see, there are many rules and eligibility concerns when you do a 1031 exchange. Although we’ve tried to simplify and condense the rules as much as possible, every exchange is different. We can’t speak for every scenario and situation. 1031 exchanges are a very complex transaction, and professional help is always needed to do it correctly. Especially with large amounts of money on the line, a failed 1031 exchange could be disastrous for those involved.
The biggest advantage of the 1031 exchange is the ability to defer taxes indefinitely. Many real estate investors are already on the path of deferring taxes until they die. Then, when they give real estate to their heirs it is on a “step-up” basis. This means your heirs will have a basis that is equal to fair-market value at time of gift, not the original basis.