Utilizing a 1031 Exchange as an investment strategy.          

April 26, 2024

When selling real estate, you may owe capital gains taxes whether you are re-investing the proceeds or cashing out entirely. However, if not cashing out yet, you can potentially defer the taxes by utilizing a 1031 Exchange.

The term 1031 Exchanged refers to Section 1031 of the IRS tax code that allows investors to sell investment property (Relinquished) and use all of the proceeds to purchase new investment property (Replacement) while deferring taxes associated with the sale. To qualify as an exchange, the Relinquished and Replacement properties must be qualified “like-kind” properties and the transaction must be properly structured as an exchange.

  •   “Likekind” from a real estate perspective means real property that has been and will be held for productive use in the investor’s trade or business or for investment. All real estate is considered the same, even if one is unimproved land and the other is an office building (or any other combination). This could include unimproved real estate, rentals, a company’s base operations, etc.
  • A 1031 exchange involves following IRS protocol, including the use of a qualified intermediary (such as IPX1031), meeting strict deadlines, and exchanging properties of equivalent value.
                                                                                                                                                              

Key Requirements NOT to Overlook

Unqualified Properties:

The relinquished property you sell must have been investment property, not your primary residence. The IRS defines a qualifying property as one not used as your primary residence, a second/vacation home (that isn’t rented most of the time – per IRS regulations), or a property held short term with the intent of flipping. Short term is vaguely defined but 2 years or more is generally considered safe.

Find a Professional:

Using a formal agreement, an investor will need to identify and secure the services of a qualified intermediary, such as a IPX1031 or Above and Below 1031 LLC. 

45-Day Deadline to Identify a Replacement Property:

Since the 1031 Exchange is considered a swap, you’ll need to designate the next property shortly after selling the relinquished property. The IRS stipulates that the replacement property(ies) be identified within 45 days from the sale of the relinquished property.

Replacement Property must = or be greater than the relinquished property

The replacement properties cost must be equal to or greater than that of the relinquished property to defer all the capital gain. Any shortage could result in the difference being taxable.  

180 Days or less to close:

The IRS also stipulates that you must close on the sale of the new property within 180 days from the sale of the relinquished property.

Securing an Exchange Escrow Account for the funds:

The funds from the 1031 Exchange must be held in an exchange escrow account with the qualified intermediary between the sale of the relinquished property and the purchase of the new property. You can’t receive them personally.

Conducting a 1031 Exchange involves a complex set of tax rules and regulations, and while this provides a snapshot, there are some critical steps to take to remain compliant.  A misstep could result in forfeiting the deferment and being subject to the capital gains tax at the sale of the relinquished property. Taking advantage of the 1031 exchange means communicating with your commercial realtor and tax advisor as you consider selling to best position you to achieve your future goals and help avoid any unintended forfeiture of deferment opportunity.

Tax Benefits of a 1031 Exchange

Whether you own property free and clear or still have a loan payment, the benefits of a tax deferred exchange may be significant. The tax dollars saved by an exchange can be used to purchase additional investment property.

Compare an exchange vs. a sale with the following assumptions:
 • Investor sells property with no debt for $1,000,000
 • The property has been fully depreciated and has a basis (original value at purchase) of $100,000
 • The property has been owned for more than 12 months
 • Assume a combined tax rate of at least 25% (federal capital gain tax, depreciation recapture, net investment income tax)

As a result, exercising the 1031 Exchange strategy in this scenario enables the investor to purchase at least $225,000 or more than the one who sells a property then reinvests with the after-tax-dollars.

Sources:

  1. Above and Below 1031 LLC

2. IPX 1031, a Fidelity National Financial Company