1031 Exchange Secrets
How to Defer Taxes & Build Passive Income in Real Estate
In This Article
A 1031 exchange is a helpful real estate tax strategy tactic used to defer capital gains taxes on the investment property you sell — after all, capital gains can be as high as 20% —but it has strict rules.
That’s why it’s important to understand the 1031 exchange timeline, as well as the 1031 exchange rules that go with it.
In this article, we'll break down both to help you understand if following the 1031 exchange timeline is right for you.
1031 Exchange Timeline Explained
Here is how the 1031 exchange timeline in 5 simple steps.
Step #1: Decide to sell your investment property and purchase a new one as a replacement
In order to qualify for a 1031 exchange, you must sell your investment property and purchase a new investment property as a replacement. Without either of these items, you cannot qualify.
Step #2: Notify a Qualified Intermediary (QI)
After deciding to sell your investment property in favor of a replacement, the next step is to notify a qualified intermediary — again, one that is qualified as well as one whom you trust — and explain that you want to do a 1031 exchange.
Keep in mind that this needs to be done prior to the sale of the investment property.
Step #3: Transfer proceeds of the sale to the Qualified Intermediary
After the sale of the investment property is complete, the next step is to transfer the proceeds to the qualified intermediary you worked with in step 2.
Step #4: Identify a replacement property
Within 45 days of the sale of the original property, notify the Qualified Intermediary of the replacement investment property.
Step #5: Close the sale of the replacement property
The final step in the 1031 Exchange timeline, close the sale of the replacement property within 180 days.
1031 Exchange Rules
Now that we’ve examined the 1031 exchange timeline, we’ll look at the 1031 exchange rules.
1031 Exchange Rule #1: Like-Kind Property
In order to complete a 1031 exchange, you have to swap “like-kind” investment property.
Both properties have to be used for the same purpose, but they can differ in many ways.
Almost any two investment properties will qualify for the 1031 exchange, like a condo for a single-family home.
1031 Exchange Rule #2: The Same Taxpayer
The property you sell and the property you buy in the exchange have to be purchased by the same person.
The names on the sale and exchange properties should match.
1031 Exchange Rule #3: Must Be Investment Property
You can only use a 1031 exchange to sell and buy investment or business property — not your residence.
1031 Exchange Rule #4: Must Equal or Greater Value
If you want a 100% capital gains tax deferment, the market value of the new property must be of equal or greater value than the investment property you are selling.
If the new property costs less, you will be liable for tax on the difference.
1031 Exchange Rule #5: Timeline
From the time you sell your property you have 45 days to select three potential replacement investment properties.
To qualify for the 1031 exchange, you must close the sale on the new property within 180 days.
Before we go any further in the nuances of the 1031 exchange and rules, let’s ensure that you understand what a 1031 exchange is — as well as its advantages and disadvantages.
What is a 1031 Exchange?
The capital gains tax is paid when you sell a property for a price higher than what you initially paid for it. This tax rate can be anywhere from 0% to 20%, depending on the amount of your sale and your filing status.
A 1031 exchange allows you to sell one property and reinvest the money into another property — capital gains tax is then deferred.
For investors, following the 1031 exchange timeline means you’re “swapping” one investment property for another.
Advantages of a 1031 Exchange
A 1031 exchange can be a great real estate tax strategy, especially for investors.
By deferring the capital gains tax, all of the proceeds from a sale can go toward another property — a tremendous advantage.
This allows investors to build their wealth without being encumbered by capital gains taxes.
Another advantage: the taxes you defer through a 1031 exchange are erased upon your death.
If you’re an investor, you can use a 1031 exchange to buy properties throughout your entire lifetime, effectively growing your wealth tax-free.
Disadvantages of a 1031 Exchange
Despite these advantages, there are disadvantages to consider when following the 1031 exchange timeline.
The 1031 exchange rules and regulations can be daunting to inexperienced investors — a big disadvantage. There’s also very little margin for error.
For example, if you use multiple 1031 exchanges but fail to complete one, your proceeds will be returned, and you may be liable for some or even all of the deferred taxes.
This is why it’s critical to use an experienced CPA or real estate attorney when utilizing a 1031 exchange — and to follow the 1031 exchange timeline thoroughly.
Types of 1031 Exchange
When following the 1031 exchange timeline, it’s important to keep in mind that there are four different types of 1031 exchange. These include:
Delayed Exchange
In a delayed exchange, you would sell the original property. The money goes to a Qualified Intermediary (QI).
The QI will hold this money in escrow until you acquire a new property.
Simultaneous Exchange
A simultaneous exchange occurs when you buy and sell properties on the same day.
Reverse Exchange
A reverse exchange occurs when an investor finds a new property before selling the old one.
Your QI (called an Exchange Accommodation Titleholder) will hold title to the new property until you find a buyer for the “old” property.
Improvement Exchange
In this type of 1031 exchange, you would identify the new property and make improvements while the QI holds title.
How To Calculate at 1031 Exchange: 1031 Exchange Calculator
When you’re going through the 1031 exchange timeline, you may wonder “how do you calculate 1031 exchange?”
You can use this real estate strategy by following these steps to determine the original basis of the property you sell:
- Determine original purchase price
- Add cost of any improvements
- Subtract any depreciation
This number will now become your original basis.
Now, determine the profit you’re making from the sale:
- Determine your selling price
- Subtract any selling costs
- Deduct your original basis from your selling price
This number will indicate how much profit you make from the sale and you can use a 1031 exchange to defer the capital gains tax.
1031 Exchange Timeline: Examples
Next, we’ll take a look at a few examples of the 1031 exchange timeline.
Changing Apartment Buildings…
Jim owns a $3 million apartment building and he wants to exchange it for an apartment building across town costing $4 million that will have higher returns from rentals.
Following the 1031 exchange timeline, he uses the 1031 exchange to qualify for a full capital gains tax deferral by purchasing a more expensive investment property.
From SFR to Duplex…
Sally owns a single-family investment property worth $500,000. Her real estate agent informs her about a duplex priced at $900,000.
Sally follows the 1031 exchange timeline to sell her single-family property and invests the proceeds to help pay for the replacement property.
The purchase price of the duplex is higher than her previous investment property, so she qualifies to defer her capital gains taxes under the 1031 exchange.
Multifamily to SFR…
Ming sold her multi-family building for $650,000. She wants to purchase a single-family investment property for $500,000, a lower price than the original property.
Because she followed the 1031 exchange timeline, she has $150,000 in profit that becomes taxable income subject to capital gains because she did not “trade up” to a more expensive replacement property.
1031 Exchange Form
You can download the 1031 exchange form, Form 8824, directly from the IRS.
You can also find the 1031 exchange form online at efile.com/tax-service/pdf/
3 Tax Implications of a 1031 Exchange
Consider these 3 tax implications before you follow the 1031 exchange timeline.
Capital gains
You may incur capital gains tax after the 1031 exchange if you end up with a profit that you don’t invest in the replacement property.
Taxed on the Difference
If the mortgage is lower on the replacement property than the investment property you sold, you might be taxed on the difference.
Using the 1031 Exchange Too Much
If you go through the 1031 exchange timeline multiple times through the years, your deferred taxes can amount to a sizable sum of money.
But keep in mind that if you die before you sell your exchange property, the IRS will forgive your capital gains taxes so your heirs can inherit the property free of capital gains tax.
The Bottom Line: 1031 Exchange Timeline
Following the 1031 exchange timeline can be a valuable real estate tax strategy — as long as you understand and follow the strict rules.
Using a 1031 exchange is one of many ways that real estate investors can build their wealth safely.
