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, eligibility, options, and various examples. You’ll get 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 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 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