Last updated on June 25th, 2021 at 10:08 am
What is a 1031 exchange? | Tax benefits of a 1031 exchange | Types of 1031 exchanges | 1031 exchange costs | 1031 exchange rules for dummies | Choosing the right qualified intermediary | Options for replacement properties | 1031 exchange example | Is it worth doing a 1031 exchange? | FAQs
This guide walks you through the rules, requirements, and variations of the 1031 exchange, a powerful investment tool with excellent tax benefits. It’ll explain, in plain English, exactly how a 1031 exchange works, and then use some examples to illustrate the details.
Think of it as “1031 Exchange for Dummies.”
What is a 1031 exchange?
A 1031 exchange allows real estate investors to “trade” one investment property for another, and defer capital gains taxes in the process.
The 1031 exchange rests on the principle that there’s no actual gain to the investor. The investor sells their relinquished property, and they purchase their replacement property, through a third-party intermediary. In the process, the investor defers their capital gains.
|Is a 1031 exchange also known as a Starker exchange?|
Yes. It’s sometimes known as a like-kind exchange, too.
👉 Important note: They’re not eliminating capital gains taxes, they’re only deferring them. If and when they sell their new investment property, they’ll have to pay those deferred gains.
One of the great things about the 1031 exchange, though, is that investors can use it repeatedly. If the investor executes a 1031 exchange again, they can upgrade to a new property while further deferring capital gains.
» LEARN THE TERMS: Check out our definitive guide to 1031 exchange terms and definitions
Many rules and timelines govern 1031 exchanges. Contact us and we’ll put you in touch with an experienced expert who can walk you through the whole process.
Tax benefits of a 1031 exchange (and more!)
The 1031 exchange isn’t really for dummies, of course. It’s for savvy real estate investors who are looking to sell or upgrade properties that have greatly appreciated in value.
Among the benefits offered by a 1031 exchange:
A 1031 exchange lets you defer federal and state capital gains taxes.
Capital gains are the increase in value of an asset from the time you purchased it to the time you sell it. If you buy a house for $200,000 and sell it for $350,000, you have capital gains of $150,000.
Capital gains on an asset you’ve owned for less than a year (for example, on a house flip) are taxed as ordinary income. For assets you’ve owned longer than a year, the capital gains tax rates:
|💰 Income||📈 Capital gains rate|
|Up to $40,000||0%|
|$441,451 and up||20%|
Let’s say you’re a long-time owner who bought an investment property 30 years ago for $300,000, and you’re selling it now for $1 million. If you fall into the highest capital gains tax bracket, you’re going to pay 20% tax on capital gains of $700,000 — a whopping $140,000 tax bill.
But if you sell through a 1031 exchange, and reinvest the sale proceeds into another investment property, you can defer those capital gains taxes.
Some examples of how much you can save via a 1031 exchange:
|Capital gains||Conventional sale (15% tax rate)||Conventional sale (20% tax rate)||Sale through 1031 exchange|
|$200,000||$30,000 taxes due||$40,000 taxes due||No capital gains taxes due|
|$400,000||$60,000 taxes due||$80,000 taxes due||No capital gains taxes due|
|$750,000||$112,500 taxes due||$150,000 taxes due||No capital gains taxes due|
And that’s not all: If you sell through a 1031 exchange, you can defer your depreciation recapture tax along with your capital gains tax.
Usually you must pay depreciation recapture tax when you sell, whether your claim depreciation on your property or not. According to IRC section 1250(b)(3), whether a rental property investor claims depreciation or not, the IRS calculates depreciation that was “allowed or allowable.”
Depreciation recapture is taxed as ordinary income (capped at 25%), so that can add up fast.
Curious how much depreciation recapture you might face? Check out our depreciation recapture calculator.
Potential higher investment returns
You can use the proceeds from your sale as a down payment on a more valuable property, which will increase your cash flow and net worth immediately.
Consolidation of investments
Between maintenance and management, owning several investment properties can be time-consuming and expensive. Many investors use a 1031 exchange to trade several investment properties for a single larger one, which reduces their workload.
» LEARN MORE: Doing a 1031 exchange with multiple properties
Diversification of investments
Exchanging a single investment property for several smaller properties in different areas can diversify your portfolio and help protect you from downturns.
For example, if you own one luxury home in Miami, and the Miami market crashes, your portfolio could take a big hit. If you own three smaller homes in Miami, Washington, D.C., and Detroit, you’re in a better position to absorb losses if one of those markets experiences a downturn.
» LEARN MORE: Turning one property into several through a 1031 exchange with multiple properties
Help with estate planning
If an investor dies while they own a 1031 exchange property, their heirs receive the property on a “step-up” basis.
This means their cost basis equals the fair market value at the time of the owner’s death, so taxes will be minimal.
Types of 1031 exchanges
The five most common types of 1031 exchanges:
- Delayed 1031 exchange
- Reverse 1031 exchange
- Improvement 1031 exchange
- Partial 1031 exchange
- Simultaneous 1031 exchange
In the spirit of the 1031 exchange for dummies, let’s cover the basics of each type of 1031 exchange.
Delayed 1031 exchange
The delayed 1031 exchange,also known as a Starker exchange or a like-kind exchange, is the most common type of exchange. When people talk about 1031 exchanges, they’re generally talking about this type of exchange.
It’s the most simple 1031 exchange, too.
In a delayed exchange, the investor contracts with a qualified intermediary (QI) to sell their property on their behalf. Once the sale goes through, the investor has 45 days to identify up to three potential replacements. The QI then purchases the replacement property or properties with the sale proceeds, and transfers the title to the investor.
This entire process must take place within 180 days, or the exchange will be invalid.
Reverse 1031 exchange
In a reverse 1031 exchange, an investor buys the replacement property first and then sells their relinquished property.
It’s often used in hot markets, where purchase opportunities are fleeting, and when investors have money on hand for an immediate purchase.
Reverse 1031 exchanges are the most expensive type of 1031 exchange. Why? Check out our definitive guide to reverse 1031 exchanges.
Improvement 1031 exchange
In an improvement 1031 exchange, also known as the build to suit 1031 exchange or the 1031 construction exchange, an investor sells a property and uses the proceeds to purchase and renovate a replacement property.
In some cases, the investor can build their ideal replacement property.
» LEARN MORE: Our definitive guide to the improvement 1031 exchange.
Partial 1031 exchange
In a partial 1031 exchange, the replacement property has a lower value than the relinquished property. The leftover cash in a partial 1031 exchange is called “boot,” which is taxable.
Because boot is taxable, and tax benefits are the main advantage of a 1031 exchange, a partial 1031 exchange can be less desirable. But investors often face it.
Learn more in our definitive guide to boot and the partial 1031 exchange.
Simultaneous 1031 exchange
In a simultaneous 1031 exchange, you find an exact match to trade for your own property. The two properties are exchanged on the same day, and at the same time.
The three main types of simultaneous 1031 exchange:
- A two-party trade, in which the two parties exchange deeds.
- A three-party exchange, when a third party “holds title” so the transaction is facilitated in a simultaneous way.
- A simultaneous exchange with the assistance of a qualified intermediary, who conducts the entire exchange.
Other types of 1031 exchanges
They exist, but they’re much more rare.
|Leasehold improvement exchange||A thirty-year (or more) lease is considered real property eligible for a 1031 exchange. The exchangor can make improvements to the leased property, via a third party, as long as the lease is maintained for at least two years, and the third party collects market rent from the exchangor.|
|International exchange||Under certain circumstances, property held outside the U.S. can be eligible for a 1031 exchange with other property held internationally|
|Three-party simultaneous exchange||Similar to a conventional simultaneous exchange, but with the addition of a third party|
If you need one of these unusual 1031 exchanges, contact one of our experts and talk it out.
How much does a 1031 exchange cost?
A standard deferred 1031 exchange costs around $1,000. Costs, of course, vary between companies.
More complicated exchanges, like the reverse 1031 exchange, run higher.
We’ve surveyed the top companies in the industry. The ranges for standard and reverse exchanges:
|🏠 Type of exchange||💰Cost range|
» LEARN MORE: The costs of a 1031 exchange
1031 exchange rules for dummies
Every 1031 exchange is different, but all are governed by common rules.
If you break any of these rules, even by accident, your exchange may be invalidated — and you’ll have to pay your taxes in full.
With so much at stake, it’s best to let an expert advise you on your 1031 exchange. Contact us and we’ll put you in touch with a seasoned expert.
The six major rules governing 1031 exchanges are:
1. Properties must be “like-kind”
To qualify for a 1031 exchange, the relinquished property and the replacement property must be “like-kind.” This sounds like they need to be similar in type, but the IRS defines like-kind broadly.
In practice, virtually any two types of real estate are like-kind. For example:
- A triplex is like-kind to vacant land
- A condo is like-kind to a farm
- An office building is like-kind to a warehouse
As long as the exchange doesn’t involve personal property or property outside the United States, it usually qualifies as like-kind.
A qualified intermediary can always help guide you.
2. Property must be for productive use in a trade or business
For a property to qualify for a 1031 exchange, it must be for “productive use in a trade or business.” The property can’t be for personal use.
In some scenarios you can perform an exchange on your primary residence. But it’s complicated.
3. Replacement property must be equal or higher in value
In a 1031 exchange, the replacement property must be equal or greater in value to the relinquished property.
If the new property is less valuable than the old one, that results in “boot,” which is taxable.
4. Must use same exchangor
In order to complete a 1031 exchange successfully, the same person must sell the relinquished property and buy the replacement.
This may seem obvious, but since many properties are held in LLC’s it can be a point of confusion.
The only exception to this rule deals with single-member LLC’s. For example, if Robert Smith owns a property in a single-member LLC, he can purchase a replacement in his actual name.
5. Identify up to three potential replacement properties within 45 days
After selling your old property, you must identify up to three potential replacements within 45 days.
If you fail to meet the 45-day deadline, your exchange may be invalidated.
Alternatively, you can identify four or more replacement properties, but their combined value cannot exceed 200% of the property sale price — and the replacement properties you end up acquiring must have a total value that’s at least 95% of the total value of the properties you identified.
6. Exchange must be done within 180 days
From the day you sell your relinquished property, you have 180 days to purchase your replacement property.
The 45-day identification period runs concurrently with the beginning of the 180-day exchange period.
How to choose the right 1031 exchange qualified intermediary
To move forward with a 1031 exchange you’ll need to work with a qualified intermediary (QI).
The IRS requires the use of a QI or accommodator to oversee the exchange, prepare the exchange documents, and ensure the exchange complies with IRS rules.
The QI actually sells your relinquished property, holds onto the proceeds during the exchange period, and then purchases your replacement property on your behalf.
This is a lot of responsibility. It requires a lot of trust.
So how do you pick out the right QI to handle your 1031 exchange?
Make sure the qualified intermediary is experienced
Your qualified intermediary should have at least 3-5 years of experience. You don’t want your QI learning on the job while they’re doing your exchange.
Ask how they’ll handle your funds
For your security, you want your funds kept in an FDIC insured bank.
You want your funds kept separate from the funds of other investors, ideally in an escrow account.
If a potential QI says your funds will be commingled with funds from other investors, it’s a potentially risky situation.
A 2004 court case ruled that if an intermediary goes bankrupt while holding investor funds, commingled funds are fair game to their creditors. Funds kept separate, in individual accounts, are not.
The last thing you want is to lose your money to a QI’s bankruptcy.
Are they insured and bonded?
Aim for a QI with coverage equal to or greater than their average amount of 1031 funds on deposit.
Errors and omissions insurance and fidelity bonds protect your proceeds in the event of a mistake or oversight on the part of your QI, or in the event of theft or fraud.
Picking out your QI is one of the most important parts of your 1031 exchange. If you’re exploring an exchange, read our in-depth guide to finding the best qualified intermediary.
Options for 1031 exchange replacement properties
1031 exchange identification rules state that both properties in a 1031 exchange must be “like-kind.” But even though the definition of like-kind is very broad, some restrictions apply.
Consult our chart below to see what kind of property is and isn’t like-kind. And remember, if you fail to obey the rules for a 1031 exchange, you may lose all the exchange’s tax benefits.
What qualifies as a like-kind replacement property in a 1031 exchange?
|✅ Qualifies as a like-kind replacement property||❌ Doesn’t qualify as a replacement property|
|Commercial office properties||Securities like cash, bonds, and mutual funds|
|Single family residential property||Properties purchased for the sole purpose of flipping|
|Delaware statutory trust (DST) interests||Personal use assets like your personal residence, second home, and vacation homes|
|Industrial properties (warehouses, self-storage facilities, etc.)||Art, cryptocurrency, and copyrights/trademarks|
|Mineral, oil, gas, timber and water rights||Ownership interests in LLCs, limited partnerships, C or S corporations|
IRS rules regarding like-kind replacement property
The like-kind rule can be confusing, so the IRS has provided some clarification on the issue. The main points:
- The replacement property doesn’t have to be in the same asset class or quality as your relinquished property to qualify in a 1031 exchange.
- The property must be held for trade, business, or investment purposes.
- Replacement properties don’t have to be located in the same jurisdiction as the relinquished property to qualify as like-kind. Replacement properties can even be located in a different state from your relinquished property, though not in a different country.
1031 exchange example
Let’s look at a simple “1031 exchange for dummies”-style example to illustrate how these rules come together.
An investor named Smith wants to sell a $1.2 million apartment building. Smith purchased the building for $500,000 two decades ago, so they’d be looking at capital gains of $700,000.
Smith’s capital gains tax bill (assuming a 20% tax rate) comes to a whopping $140,000. On top of that, they’ll have to pay depreciation recapture tax.
Smith claimed just over $18,000 a year in depreciation (depreciation is calculated by dividing the property value by 27.5). Since they owned the property for 20 years, they’ve claimed a little more than $360,000 in depreciation.
Depreciation recapture is taxed at income tax rates, capped at 25%. Assuming the highest depreciation recapture tax rate, that’s another $90,000 in taxes, for a total tax bill of $230,000.
Instead of paying 20% in capital gains tax ($140,000) and 25% in depreciation recapture tax ($90,000), Smith decides to sell the building through a 1031 exchange and diversify into multiple properties.
Smith contracts with a qualified intermediary (QI), who sells the building. This starts the clock on the 180-day exchange period and the 45-day identification period.
Smith has 45 days to identify up to three replacement properties. Alternately, they could identify multiple properties valued at up to 200% of the relinquished property’s sale price — but they’d also have to close on at least 95% of their total value.
While the QI holds onto Smith’s sale proceeds, Smith looks at properties. They identify three single-family homes within 45 days that come to a total of $1.2 million.
With the sale proceeds from the sale of the relinquished building, the QI purchases the three single-family homes. These sales must close within 180 days of the initial sale, and within 135 days of the end of the identification period. If they don’t, Smith could lose all tax deferral benefits.
Once the sales go through, the QI transfers the titles of the properties to Smith. Because the QI conducted the actual transaction, and Smith never actually pocketed any gains, the 1031 exchange allows Smith to defer their capital gains — saving Smith $230,000 in taxes.
Is it worth doing a 1031 exchange?
As we touched on, capital gains taxes can run as high as 20%. So if you’re looking at a capital gains tax bill, a 1031 exchange can offer massive benefits.
Aside from that, a 1031 exchange offers a streamlined way to expand or consolidate your real estate holdings while deferring capital gains.
But is a 1031 exchange right for you? Everyone’s situation is different, so there’s no easy one-size-fits-all answer.
A good starting point: Consult with one of our seasoned 1031 exchange professionals, who can lay out your options and walk you through every relevant scenario.
FAQs about 1031 exchanges
How long do you have to hold property in a 1031 exchange?
There’s no required holding period specified in tax law, but most experts suggest holding a 1031 exchange property for at least two years.
If you sell quickly, and the IRS concludes your purchasing intent was a quick profit instead of investment, they could invalidate your exchange.
Can you live in a 1031 exchange property?
You can eventually move into a 1031 exchange property and convert it into your primary residence.
But if the IRS suspects that you purchased the property with the explicit intent of using it as a primary residence, they could invalidate your exchange.
IRS guidance says you should wait two calendar years after your 1031 exchange before occupying your replacement property.
In some cases you can move in after one year, but it carries a tax risk.
Can you 1031 exchange a second home?
A 1031 exchange can only be used on an investment or business property, so in order to use a 1031 exchange on your second home, you’d have to first convert it into a rental.