What Is a 1031 Exchange? – PEGGY HOAG REAL ESTATE
Are you moving and considering selling your investment property?
Maybe you are looking for a way to boost your real estate portfolio.
Either way, you’ll want to know about the 1031 exchange.
In this guide, we’ll answer your questions, including,
- What is a 1031 exchange?
- What are the 1031 exchange requirements?
- How do I decide if a 1031 exchange is right for me?
Table of Contents
- What is a 1031 Exchange?
- 5 Important 1031 Exchange Requirements You Need to Be Aware of
- What Are the Pros and Cons of a 1031 Exchange?
- 5 Pros of a 1031 Exchange
- 3 Cons of a 1031 Exchange
- Ready to Begin Your 1031 Exchange? The Experienced Professionals at Peggy Hoag Real Estate Can Help
What Is a 1031 Exchange?
A 1031 exchange is named after Section 1031 of the U.S. Internal Revenue Service Code.
Also referred to as a “like-kind” exchange, a 1031 allows you to postpone paying capital gains taxes on the sale of an investment or business property as long as the proceeds from the sale are used to reinvest in a similar property.
The transaction must take place within a specified amount of time, and the new property must be of “like-kind” and of equal or greater value.
For example, say you plan to move away from Portland and no longer want to worry about the upkeep and management of your Portland rental property.
By using a 1031 exchange, your Portland rental can be sold without incurring tax, as long as you purchase investment property of “like-kind” (equal to or greater value and equal to or greater debt).
You will then have 45 days to identify after the close of escrow on your property and 180 days to finalize the deal.
1031 Exchange: Stipulations Regarding the 180-Day Rule
After closing a relinquished property, taxpayers usually have 45 days to identify the new property and 180 days to finish the purchase.
For those who have started exchanges between October 18, 2023, and December 31, 2023, the timeline is shorter than 180 days.
Why?
Tax Code states that any Replacement Property must be purchased by the earlier of two dates:
- 180 days after the date the Relinquished Property is transferred to an exchange
Or
- By the due date of the taxpayer’s return for the taxable year in which the property is transferred.
What does that mean?
Taxpayers who sold real estate and began a 1031 Exchange after October 18, 2023, are required to close on the new Replacement Property by the time their 2023 tax return is due: April 15, 2024.
Let’s say, for example, an investor sells a property on December 15, 2023. They must identify the new Replacement Property by January 29, 2023, *45-day rule). Then, the investor must close by April 15, 2024 — NOT June 13, 2024 — because of Tax Code Section 1031 (a)(3)(B).
If the taxpayer would like the full 180-day period, they must file an extension for their entire tax return.
If you’re concerned you may be affected by these stipulations, be sure to consult your tax advisor for more information about requirement dates and what you can do to receive the full 180 days.
5 Important 1031 Exchange Requirements You Need to Be Aware of
#1: 1031 Only Applies to Business or Investment Properties
A key rule about 1031 exchanges is that they’re generally only for business or investment properties.
Property for personal use — like a vacation home — typically does not qualify. Additionally, securities and financial instruments, such as …
- Partnership interests
- Stocks & bonds
- Certificates of trust
- Debt instruments; and
- Inventory
… are usually ineligible for 1031 transfers.
#2: You Have to Follow a Tight Timeline
If you do a 1031 transfer, you’ll want to keep a close eye on the calendar.
Once your property has sold, you have a strict time frame that includes a:
- 45-day deadline to identify a replacement property; and
- 180-day deadline to complete the transaction on the new property. It is important to note that this time frame is a straight 180 days — not 45 days plus 180 days.
#3: You’re Required to Pay Taxes
A 1031 exchange doesn’t remove the obligation to pay capital gains tax — it just defers it.
Capital gains are the result of selling an asset for more than you paid for it.
For example, if you purchased a rental property for $97,000 and sold it for $129,000, you have a capital gain of $32,000.
With a 1031 exchange, you will not be required to pay capital gains tax on the sale of your first property. However, you will be taxed on the amount of depreciation if your property sells for more than its depreciated value.
#4: You Must Use a Qualified Intermediary
Another one of the 1031 exchange requirements is that a qualified intermediary must facilitate the exchange.
Referred to as a QI, the qualified intermediary is the individual who holds funds from the initial property and uses them for the acquisition of the replacement property.
Per the IRS 1031 rules, these funds remain in the possession of the QI, rather than the property owner.
#5: 1031 Can Only Be Used for a Like-Kind Purchase
One of the key 1031 exchange requirements is that it can only be used for the purchase of a property of “like-kind.”
According to the IRS,
“Properties are of ‘like-kind’ if they’re of the same nature or character, even if they differ in grade or quality.”
If you’re going through the 1031 exchange process, hiring a real estate broker who has experience in 1031 transfers is critical.
The agents at Peggy Hoag Real Estate are well versed on the ins and outs of the 1031 process and can help you keep within the timeline requirements and direct you to potential properties that meet your specific needs.
What Are the Pros and Cons of a 1031 Exchange?
The pros of doing a 1031 exchange include the ability to:
- Diversify your portfolio
- Reset your depreciation
- Invest in a variety of markets
- Trade up; and
- Build equity
The cons include:
- The strict timeline
- Still having to pay taxes; and
- The challenge of finding “like” properties
5 Pros of a 1031 Exchange
#1: You Can Diversify Your Portfolio
One of the unique opportunities of doing a 1031 exchange is the ability to diversify your real estate portfolio.
For example, if you own a single-family rental property in a highly appreciated market, you may be able to exchange it for multiple properties in an area with a less volatile market.
You also can change properties based on your desired level of involvement, such as selling an apartment complex that has a high turnover rate and excessive maintenance for a long-term lease, single-family rental.
#2: You Can Reset Your Depreciation
The 1031 exchange process allows you to reset the depreciable amount of your investment property to a higher amount, giving you a larger yearly tax benefit.
#3: You Have the Opportunity to Invest in Various Markets
When you do a 1031 exchange, you have the opportunity to utilize one of the greatest advantages of investment real estate, the ability to diversify risk.
Since 1031 exchanges have no state-to-state restrictions, you can analyze the market and make an investment that has a high potential for growth. That can translate to big returns for you.
It’s key to remember, however, that depending on the state, you may be required to pay a capital gains tax.
#4: You Can Trade-Up
A 1031 exchange allows you to trade up.
You can invest in a property (or multiple properties) that meets your investment goals and can give you a higher return on your investment — without having to pay taxes on the new property.
#4: You Can Trade-Up
A 1031 exchange allows you to trade up.
You can invest in a property (or multiple properties) that meets your investment goals and can give you a higher return on your investment — without having to pay taxes on the new property.
#5: You Have the Potential to Build Equity
One of the great things about the 1031 exchange process is that there is no limit to the number of exchanges you can do.
That means you can begin with a low-key investment and continue trading up to build equity.
3 Cons of a 1031 Exchange
#1: There’s a Strict Timeline
As we discussed above, 1031 exchange requirements include a tight timeline.
You have 45 days from the sale of your original property to identify your new property and 180 days from the sale of said property to close on the exchange.
#2: You’re Taxed on the “Boot”
The “like-kind” 1031 exchange properties must be of similar value.
Any difference in value between the two properties is referred to as “boot” and is subject to taxation on capital gains and accumulated depreciation.
#3: Finding “Like” Properties Can Be a Challenge
One of the 1031 exchange requirements is that the new property needs to be of “like-kind” — and must be identified within the 45-day window.
This is why planning ahead is critical. As soon as you know you may be interested in the 1031 exchange process, begin your property search.
Delaying may mean that you wind up:
- Scrambling to find a like-kind property that isn’t what you’re really wanting; or
- Failing to find a suitable replacement property and having to pay the full force of taxes on the sale of your original property
Ready to Begin Your 1031 Exchange? The Experienced Professionals at Peggy Hoag Real Estate Can Help
At Peggy Hoag Real Estate, we know 1031 exchanges.
Our professional brokers can:
- Help you find and hire a QI
- Identify high-quality replacement investment properties for your exchange
- Set you up with our network of trusted lenders
- Talk with you about managing your luxury property; and
- Guide you through the 1031 timeline
Contact us today for more information.