What is a 1031 Exchange?

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The real estate market has been quite interesting the last few years. A lot of people have seen large increases in the value of investment real estate they own. Many have sold to take advantage of those increases and make a big profit! But the downside of profit means taxes. What if there was a way to defer or avoid those taxes?

In comes the 1031 Exchange (also called a Like Kind Exchange). You need to know about this BEFORE you sell so that you can plan it all out correctly! First and foremost, the 1031 Exchange does not apply to your primary home (mainly because your primary residence has it's own set of rules for taxes and gains). The 1031 Exchange applies to investment real estate or real property used in a business. The term real property here refers to land and any permanent structures attached to it.

So what exactly is a 1031 Exchange?

In a nutshell, a 1031 Exchange is a swap of one property for another that allows capital gains taxes to be deferred. The properties must be like-kind meaning they have a similar nature. It doesn't mean they have to be the same size or type though. For example, you could exchange an apartment building for a shopping center.

How does the 1031 Exchange work? Let's walk through an example using the apartment building for a shopping center just mentioned.

Sally owns an apartment building that rents apartments to tenants. She no longer wants to be involved in this operation and instead wants to own a shopping center that rents to small business tenants. Sally wants to do a 1031 Exchange so she begins making her plan before she even lists the apartment building for sale. It is important to note that you have to do the steps of the 1031 Exchange exactly right or it will be disallowed. In a perfect world, Sally would know someone with a shopping center that also wanted to get rid of it and get an apartment building and they would literally exchange the properties. However, we all know the likelihood of that type of exchange is very slim. Therefore, delayed or three party exchanges are much more common.

Basically what happens here is that Sally would sell the apartment building and the money from that sale would be held by a qualified intermediary that acts as a middleman. Then the money that the middleman is holding would be used to buy the new shopping center. Sally can not receive the money and hold it or it would void the 1031 status of the exchange.

That sounds pretty simple but there are some very specific timing rules that must be followed. The first one is the 45 day rule. This states that within 45 days of selling the old property, in this case the apartment building, Sally must designate, in writing to the middleman, a replacement property. She can designate up to 3 but must close on one of those three. The second is the 180 day rule. This states that within 180 days of selling the old property (Sally's apartment building) that you must close on the new property, the shopping center. So if Sally sold her apartment building on April 1, she would have to designate the replacement property by May 15 and close on the new shopping center no later than September 28 (which would be 180 days).

If Sally sells the apartment building for more than the cost of the new shopping center then that overage is subject to taxes. Generally, people use the 1031 exchange to upgrade to more expensive properties but in the case they go to a less expensive property then there will be some tax involved. There can also be some tax implications if there is a loan on the properties and a decrease in the total loan amount occurs from the old property to the new. That gets more complicated so we are not going to dive into the weeds of that here.

Continuing with Sally's example, let's examine how the deferment of the capital gains tax works. Let's say Sally originally purchased her apartment building for $500,000 (we are going to ignore depreciation in an effort to keep this example straightforward). When she decides to sell her apartment building, it is worth $750,000. So, if she sold it in a standard transaction for $750,000 then she would have capital gains of $250,000 to pay tax on. Say the new shopping center she acquires in the 1031 exchange has a purchase price of $750,000. Generally, Sally's basis (essentially her cost) in the shopping center would be the $750,000. However, in the 1031 exchange her basis in the shopping center will be the $500,000; the original basis of the apartment building (remember we are ignoring depreciation to keep this example simple). That is how the capital gains is deferred. Sally could continue doing 1031 exchanges or she could outright sell the shopping center. If she decided to outright sell the shopping center 5 years later and sold it for $1,000,000 then her capital gains would be $500,000 ($1,000,000 sell price less the $500,000 basis from the 1031 exchange). Had she not bought the shopping center in the 1031 exchange and had the $750,000 basis then her capital gains would be $250,000.

You may be asking, does this work with a vacation home? The short answer is no, not anymore. There are some technicalities still lingering but generally speaking, that ship has sailed. However, if you have a home that is an Air BnB and generates income then that would most likely qualify.

It's important to note that a 1031 exchange doesn't eliminate tax it just defers it until a later sell. However, if you are using 1031 exchanges as an estate planning tool you can even get around that. Let's continue with Sally's example above. Sally had an apartment building with a cost basis of $500,000, she sells it for $750,000 and in a 1031 exchange acquires a shopping center for $750,000. She deferred $250,000 of capital gains in the exchange. Today the shopping center is worth $1,000,000 so if she outright sold it there would be the $500,000 of capital gains that we mentioned above. If Sally dies today and her will leaves the shopping center to her son Ben then Ben will avoid the capital gains. How you may ask? Because Ben will receive what is called a step up in basis when he inherits the shopping center. That means Ben's basis will be the market value at the time of Sally's death, the $1,000,000. If Ben sold it for $1,000,000 then he would have no tax liability on the sale.

How about that? That is surely food for thought!

With the large increases in market values over the last few years, 1031 exchanges are becoming more of a main stream topic so that people can defer the capital gains or create an estate plan for their heirs around appreciating real estate. If you are considering doing a 1031 exchange, you want your "middleman" to be very qualified to handle the transaction. It would be a very bad day if the IRS decided to disallow your 1031 exchange because a small technicality was missed.

Information contained in this post is for educational purposes only and is not considered financial advice.