A 1031 exchange is a type of transaction that allows real estate investors to defer capital gains taxes when selling an investment property and reinvesting the proceeds into a new property. Under Section 1031 of the Internal Revenue Code, one can avoid paying capital gains taxes on the sale of an investment property if you reinvest the proceeds into a similar (referred to as “like-kind”) property within a specified timeframe. This allows your investment from the first property to continue growing tax-deferred.
To begin the 1031 exchange process, you must identify the property you want to sell, which must be held for investment or used in a business. Personal residences and vacation homes typically don’t qualify. Next, you choose a qualified intermediary (QI), an essential party who facilitates the exchange by holding the funds from your property sale and then transferring them to purchase the new property. This ensures you don’t take possession of the proceeds, which would disqualify the exchange.
Once you have a buyer for the property and close the sale, the proceeds go directly to your QI, not to you. Then, you have 45 days from the sale date to identify potential replacement properties in writing to your QI. You can identify up to three properties of any value, or more if they fall within certain valuation limits. You must then close on the new property within 180 days of selling the old one. The purchase price of the new property must be equal to or greater than the sale price of the old property to defer all capital gains. If you buy a less expensive property, the difference in price (referred to as “boot”) is taxable. Finally, you report the details of the exchange to the IRS using Form 8824 when you file your taxes for the year of the exchange.
There are a few different ways to structure a 1031 exchange. The most common type is a delayed exchange, where you sell your original property first and then buy the replacement within the 180-day window. A simultaneous exchange is when the sale of your old property and purchase of the new one occur on the same day. Lastly, a reverse exchange is when you buy the replacement property first and then sell your old property within 180 days, which requires more advanced planning and financing.
There are some key rules and considerations to keep in mind. The properties must be “like-kind,” meaning they’re of the same nature or character, even if they differ in grade or quality. Most real estate is considered like-kind. You must identify replacement properties within 45 days and complete the exchange within 180 days, and these deadlines are strict. The replacement property must be of equal or greater value to fully defer capital gains taxes, but you can do a partial exchange, deferring taxes on only part of the gains, if you don’t reinvest all the proceeds. 1031 exchanges can be used for properties that are eventually converted to personal use, but there are specific holding period requirements to be aware of.
While the 1031 exchange process is complex, it’s a valuable strategy for real estate investors looking to defer taxes and keep more of their money working for them. With careful planning and expert guidance, you can use this powerful tool to build and preserve wealth in your real estate portfolio.
From my perspective, it’s certainly worth pursuing a 1031 exchange if you are an avid real estate investor with interest in deferring the taxability of gains into the future. However, it is imperative that the proper steps are taken, so that any unintended capital gains tax consequences can be avoided. Additionally, proper planning and identification of a like-kind property will aid in reducing the stress involved with completing the transaction within such a limited time frame. Keep in mind, the additional form filing requirements for your taxes may also increase tax compliance costs. These additional costs will need to be factored in when assessing whether or not deferring the gain will actually save you money at the end of the day. If you have any questions on this, please feel free to reach out and I can help research your particular situation.
Resources & Articles:
https://www.irs.gov/instructions/i8824
https://www.irs.gov/forms-pubs/about-publication-544
https://pointacquisitions.com/commercial-real-estate/insights/1031-exchange/process/
https://www.sarsillc.com/the-complete-guide-to-executing-a-1031-exchange/
Nathaniel Sanborn, CPA 
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