The Basics of a 1031 Exchanges

December 17, 2023by Brian Walsh

If you’re a US taxpayer investing in US real estate, you’ll inevitably come across the idea of the “1031 Exchange.” Someone has already probably told you that you have to do a 1031 exchange to avoid paying taxes. What does this mean? Isn’t that illegal?

A 1031 is actually perfectly legal — in fact, it’s named after a line in the US tax code. And while most of the US tax code is more incomprehensible than the Rosetta Stone, the basics of a 1031 are actually not that hard to understand. Here are the basics of a 1031 exchange, including the role of the title company in the process.

What Is a 1031 Exchange?

A 1031 exchange is named after Section 1031 of the Internal Revenue Code.

This section stipulates a specific circumstance under which you, as a real estate investor, can sell your property for a profit (i.e. more than you paid for it initially) and avoid paying Federal capital gains taxes on that profit.

How do you do that? By using the proceeds from the sell to buy another property. Hence the “exchange” in the term “1031 exchange.”

Here’s a basic example. Let’s say you put $40,000 down on a $200,000 investment property. Five years later, you sell the property. Once you pay off the mortgage and closing costs, you’re left with $80,000 in proceeds. You doubled your money … but that $40,000 profit is subject to long-term Federal capital gains taxes of up to 20%.

But if you decide to do a 1031 exchange, you can use that $80,000 to purchase a new investment property. Maybe a 20% down payment on a $400,000 property … or a higher down payment to reap more cash flow. The point is, you can accelerate your real estate appreciation and income much faster if you don’t take that big tax hit.

It’s important to note that you’re not avoiding or evading these taxes — you’re simply deferring them. If you ever take personal possession of the sale proceeds, they will be taxable … even if you take those proceeds decades into the future.

However, if you keep flipping the proceeds of the sale into new real estate investments, never taking the proceeds as cash, you can effectively defer those taxes indefinitely, taking more and more cash flow in the form of rent revenue and refinance proceeds and paying no capital gains taxes for decades.

The “Like-Kind” Property Rule

The law specifies that this exchange must be a “like-kind” exchange, but this doesn’t mean that you can only exchange a house for another house. It’s allowed to exchange land for developed property, residential property for commercial property, and vice-versa. You can also exchange property in one state for property in a different state (but not foreign real estate). 

What’s not allowed is to exchange investment-use property for property that you intend to use for personal use (i.e. live in). Nor can you exchange your real estate holdings for stocks, bonds, partnership shares, or other asset classes under the tax protection of a 1031 exchange.

The Timeframe of a 1031 Exchange

Because the IRS wants its money, it won’t let you wait forever to flip your sale proceeds into the next property. A 1031 exchange is therefore governed by two strict deadlines:

  • 45 days to identify the property. You must report to the IRS what specific property you intend to buy with the proceeds within 45 days of closing escrow on the sale of your original investment property.
  • 180 days to close. You must close on the identified property within 180 days of the closing of the original property.

If you miss either one of these deadlines, the proceeds are considered “boot” (see below) and are fully taxable.

The Qualified Intermediary

One of the key components of the 1031 exchange is that you never actually take personal possession of the cash proceeds from your property sale. After all, whenever you get paid, the IRS wants a piece. 

So the 1031 exchange is structured such that while the money remains a part of your net worth, you never technically get paid. Instead, the funds are received in trust by a professional called a Qualified Intermediary (QI). A QI is licensed by the Federal government to facilitate 1031 exchanges. 

The QI is usually also responsible for filing the necessary paperwork (i.e. reporting the intended exchange property to the IRS, etc.) They often keep track of deadlines, but they won’t find the property for you. It’s your job to find the exchange property and tell your QI in time to make the 45-day identification deadline, and it’s your job to close the transaction on that property within the 180-day closing deadline.

Downsides of a 1031 Exchange

While most real estate investors consider it a huge boon to defer capital gains taxes, there are downsides to a 1031 exchange:

  • You Can’t Use the Sale Proceeds. While it is possible to flip the proceeds into a better cash flow or refinance position, you can never actually spend the proceeds of the sale. It has to stay invested in property to qualify for 1031 tax deferral.
  • You’re a Motivated Buyer. Because of the strict time deadlines, you basically have to buy property or face a big tax bill. This puts you at a strategic disadvantage. If you’re selling at the top of a market cycle, you might be tempted to buy again into that seller’s market unless you can identify a buyer’s market in a different city, state, or asset class. If the seller finds out that you’re looking for a 1031 exchange, they may use the time-sensitivity of the transaction as a bargaining chip against you — especially after the 45-day identification period when you are basically locked in.

The Title Company’s Role in a 1031 Exchange

The role of the title company is similar to its role in any real estate transaction — opening escrow, holding funds in trust, ensuring fulfillment of the contract terms, issuing title insurance, and performing legal due diligence on the title.

A title company may also act as the 1031 intermediary. Many title companies can also act as Qualified Intermediaries (QI) for your 1031 exchange. If not, they can often refer you to a QI. Since they have fiduciary custody of the funds in a trust account, it makes some sense to let them act as the third-party intermediary for your 1031 exchange as well.

1031 Exchange FAQ

What Happens if I Pocket Any Of The Profits From the Sale?

If you pocket part of the proceeds of a sale of a home, even if the rest of the proceeds go into a 1031 exchange, the industry term for this cash is “boot.” Because you have taken possession of that cash, it is taxable in proportion to what the entire tax burden would have been. 

For example, if you take 10% of the sale proceeds as “boot,” you would pay 10% of the capital gains taxes you would otherwise be required to pay if you had pocketed all of the proceeds.

Can I Buy More than One Property with my 1031 Exchange?

Yes, you can purchase up to three separate properties with a single 1031 exchange. All the same rules and deadlines still apply to each property. If you want to buy three properties, all three must be identified in 45 days or less, with closing in 180 days or less; otherwise, the leftover proceeds are “boot” and are taxable. 

Also, you are usually not allowed to purchase multiple properties whose combined value exceeds 200% of the value of the original property.

Can I Switch Properties in the Middle of a 1031 Exchange?

You can switch properties for the exchange within the 45-day identification period. After that, you are not allowed to switch properties — you either close on the identified property, or take boot.

Can Homeowners Do a 1031 Exchange?

No, the 1031 exchange is a tax advantage available only to real estate investors. Personal residences are not eligible. However, for their personal residence, homeowners are eligible for the Homestead Exemption, which makes up to $500,000 of sale proceeds permanently exempt from long-term capital gains taxes.

Can I Do a 1031 Exchange on a Fix-And-Flip?

Usually not. Fix-and-flip properties are usually taxed as “inventory,” not “investments,” under the ordinary income rules. If you hold your flip for longer than a year, however, long-term capital gains rules may kick in and a 1031 exchange may be an option.

Can I Buy the Next Property in the Name of a New LLC?

The property has to be acquired in the name of the same taxpayer as acquired the original property. Entities can be structured to create almost any outcome you want, but for the exchange to be valid, the purchaser of the next property must be the same taxpayer as the purchaser of the original property, whether that’s you personally or a corporation, LLC, trust, etc.

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