The 1031 exchange can help you defer capital gains tax while you reinvest the profits from an initial investment into a new property, or a series of them. But investors must be careful to follow a few important rules, or risk losing those tax advantages.
For some people, buying their first property is an end in itself. But for others, closing on that first property is only the initial step in building up a lucrative, diversified real estate portfolio.
One of the best tools to make that leap from a single property to a real estate empire is the 1031 exchange, but it can be a complicated process. If the rules aren’t followed, an investor can find themselves exposed to serious tax liability, which could endanger not only their profits, but their property holdings as well.
Before you can parlay that first property into a seven-figure empire, find the right property for your initial investment.
The only foolproof way to do that is to partner up with a knowledgeable local agent, who knows the market and can negotiate the best price for you. Get in touch with a top agent in your area for a free, no-obligation consultation.
What is a 1031 Exchange in Real Estate?
To put it simply, a 1031 exchange is a tool in the U.S. tax code that allows you to reinvest the proceeds from a property sale paying no capital gains taxes on that money.
Why is this such a valuable opportunity? Real estate is often considered the safest investment because the real estate market itself has been on a reliably upward trend. Supply and demand govern the profitability of an investment, and there is a hard limit on the supply of real estate, especially in dense urban markets.
On a real estate investment, the main threats to your long-term profits are sudden, catastrophic downturns in the market, which are rare events that only happen once every few decades, and are inevitably followed by recoveries, and taxes. The capital gains taxes on a real estate sale can range up to 20%, which can take a significant bite out of your profits.
For example, if you sell an investment property for $1 million, which is an average or even below average price in many of the priciest urban markets, you could owe the government up to $200,000. Obviously, you’d like to avoid this if you could. Enter the 1031 exchange.
A 1031 exchange works like this: when you sell a property, you can reinvest the proceeds from that sale into another similar property, or multiple similar properties, as long as you do so within the timeframe mandated by the IRS, and follow a few simple rules.
Rules of a 1031 Exchange
First, you don’t have an unlimited amount of time to reinvest the proceeds from the initial sale. From the day you close on the sale of the first property, you have 180 days to close on the sale of the subsequent reinvestment properties. If you don’t close within that six month period, you forfeit the tax benefits of a 1031 exchange.
Second, there are very specific restrictions on what kind of properties you can reinvest in. This rule is often referred to as the "like-kind" rule. The IRS requires that the property you reinvest in is like-kind to the property you just sold.
So if you just sold a single family home, you can’t put the proceeds into, for example, an office building and still benefit from a 1031 exchange. However, you could sell a single family home, and reinvest the proceeds into a duplex, and still gain the tax advantages from a 1031 exchange.
Third, your subsequent property must be equal to or greater in value than the initial property. You aren’t restricted to a one-for-one exchange, though; you can actually reinvest in multiple properties, as long as their combined value is equal to or greater than the initial property, though there’s more to this rule, which we’ll detail below.
There are other restrictions, too. If the property you’re selling is your primary residence, it isn’t eligible. Fix-and-flips aren’t eligible for a 1031 exchange, either; the properties must be long-term rentals. The 1031 exchange is aimed at big picture, long-term investors.
The restrictions discussed above give the general outlines of the 1031 exchange, but there are other, more complicated rules, primarily concerning the quantity and value of eligible 1031 properties. Let’s look at three of the most important ones: the three property rule, the 200% rule, and the 95% rule.
What is the Three Property Rule?
Because finding the right property for a one-to-one exchange within the 180 day period of eligibility can be difficult, the rules allow for you to target up to three properties for reinvestment.
You have a 45-day "identification period" in which to identify up to three properties that you could potentially buy with your sale proceeds. You’re not committing to buying all three properties; you only have to close on one or more, though keep in mind that whether you buy just one or all three, the value of your reinvestment still has to be equal to or greater than the property you just sold.
The 45-day identification period is strictly enforced; you must deliver the specific addresses of your three properties to the 1031 exchange by the close of the 45th day, even if that falls on a holiday or weekend. But like many of the 1031 exchange rules, the three property rule has a few interesting wrinkles.
What is the 200% Rule?
In the event that you’d like to target more than three properties, you’re allowed to do so, as long as the aggregate value of the targeted properties doesn’t exceed 200% of the value of the property you just sold. So, for example, if you sell a $1 million property, you can target more than three subsequent properties if, in total, they don’t exceed $2 million in value.
But the 200% rule comes with a very important condition: the 95% rule.
What is the 95% Rule?
If you use the 200% rule to exceed the three property limit, you then trigger the 95% rule, which states that you must close on at least 95% of the combined value of the targeted properties within the 180 day exchange period. If you fail to do so, you forfeit the tax advantages of the 1031 exchange, and you’re liable for a capital gains tax bill.
For this reason, the 200% rule and the 95% rule should be considered aspects of the same rule, as the former always triggers the latter.
There’s no better way to navigate 1031 exchanges than by partnering with an experienced real estate agent. Working with a top agent who knows which way the wind is blowing will make your property search faster and your investments safer.
Clever Partner Agents are top performers in their markets, and can help you confidently navigate your investment journey. If you’re ready to build your portfolio, contact us today for a free, no-obligation consultation!
Top FAQs About 1031 Exchanges in Real Estate
What happens when you sell a 1031 exchange property?
When you use a 1031 exchange, you’re only delaying your capital gains tax liability, not canceling it out permanently. So when you sell a 1031 exchange property, you’re then liable for the capital gains tax that you carried over from the initial property.
It’s important to be prudent in your subsequent 1031 exchange investments. If you reinvest in a healthy market, your profits from your subsequent investments will eventually exceed the capital gains you’re carrying from your initial property, which is the real power of the 1031 exchange, especially when you consider that you can sell and reinvest using a 1031 exchange multiple times.
But if your subsequent investments don’t appreciate, you could end up taking the double hit of selling that property at a loss, besides having to pay capital gains on the previous sale or sales.
What are the benefits of a 1031 exchange?
A 1031 exchange allows you to put off your capital gains tax bill, and reinvest the proceeds from a property sale into a second property, or into multiple properties. This allows you to fully invest your profits into new properties, deferring your tax liability until a time when your holdings have grown exponentially.
Can you move into a 1031 exchange property?
The 1031 exchange is intended to be used for business or investment properties, so using a 1031 property as a personal residence would invalidate the exchange and its advantages. However, there are exceptions to this rule.
If you can prove that you intended to use the 1031 exchange property as an investment, but experienced a change in circumstances that forced you to use it as a residence, you might maintain the advantages of the exchange. Anecdotally, renting the property for a year usually meets this threshold of intent.
The specific IRS rules governing this requires that you held your 1031 exchange property for 24 months after the exchange, and that in each 12-month segment of that period, you rented the property at a fair market rent for at least 14 days, and that your personal use of the property doesn’t exceed 14 days or 10% of the number of days during the 12-month period when the property is rented, whichever is greater.
What qualifies as a like-kind property?
To qualify as a like-kind property under a 1031 exchange, the replacement property must be of the same general type as the initial property that’s being sold.
For example, if you’re selling a single family home, another single family home, or even a multi-family property would qualify as like-kind, but an office building or farmland would not.
How do I file a 1031 exchange?
To file a 1031 exchange, you must contract with a qualified intermediary who’ll execute the actual financial transaction, under the direction of you and your agent, and make sure you meet all the legal requirements. Also known as an exchange facilitation company, they’ll facilitate the transfer of properties between you and the other parties, and hold the transferred funds in escrow during the transitional period. This will ensure that you meet the strict definition of a true transfer, and never have possession of the funds from the sale.
How long do you have to hold a 1031 exchange property?
There’s no legal requirement for how long you have to hold a 1031 exchange property to qualify for the tax advantages. However, if you "flip" the property quickly after purchase, the IRS might conclude that you didn’t intend to hold the property for investment, and they could invalidate the exchange.
The consensus is that you should hold a 1031 exchange property for at least a year before selling, to prove your sincere intent to invest long term. While there’s no existing time requirement in the tax laws, the IRS has proposed a one-year requirement more than once, which suggests they view this as a reasonable threshold.
As long as you’re careful to follow all the rules and regulations associated with the 1031 exchange, it can be one of the most powerful tools out there to grow your real estate portfolio. Savvy investing combined with the 1031 exchange can parlay a single, initial property into a lucrative real estate portfolio much faster than if you were simply investing in a succession properties and paying capital gains on each sale. One of the key elements of this equation, along with a comprehensive understanding of the 1031 exchange’s requirements, is making the right investments.
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