​What a 1031 Exchange is and Why You Should Care

Ever heard of a 1031 Exchange? The average Joe probably hasn’t, but if you’re an active real estate investor, chances are you’ve heard the term. But how much do you really know about it? And, more importantly, are you using this tax loophole to your advantage when it’s time to sell your investments?

The 1031 Exchange

Would you believe me if I told you that the IRS invented the 1031 Exchange as a benefit to you, the investor? I know it seems far-fetched, because it is the IRS we’re talking about, but it’s true. This fun little tax law actually allows investors to defer paying taxes on the capital gains they receive from the sale of a property - so long as that cash is leveraged into another investment.

Of course, the IRS wouldn’t do something like this solely for your benefit. They’ll get their piece of the pie in the end, and there’s a good chance their piece will be even larger than it would have if you didn’t do the 1031 Exchange.

However, there is still tremendous benefit to investors who use this strategy when buying and selling properties. Using a 1031 Exchange saves you thousands on taxes, and as long as you keep using it every time you sell/buy, those taxes are deferred!

Sound too good to be true? It’s really not. Here’s how it works:

1. You decide to sell your investment property. You bought it for $100,000, now it’s worth $200,000. That $100,000 in capital gains would normally be taxed by the IRS, resulting in a hefty payment you would owe Uncle Sam.
2. Using a 1031 Exchange, you are allowed to roll that $100,000 profit into the purchase of another property, deferring the taxes on it. Cha-ching!
3. You are allowed to do this as many times as you want, so long as you’re following the IRS’s rules regarding the 1031 Exchange (I’ll explain these in a minute).
4. If/when you’re ready to end your investment career, you’ll be required to pay the taxes on the accumulated capital gains of any and all properties you 1031’ed. This can be a sizable chunk of change, depending on how much profit you amassed over the course of your career.
5. OR, you can choose to retain ownership of the property or properties until your death, leaving the assets to your heirs. Your beneficiaries can decide what to do with them at that point, and if they choose to sell, the tax consequences are usually absorbed by the IRS (obviously, talk to your tax pro and a real estate attorney because there are certain rules and regulations that apply to this scenario, and you don’t want to leave your kids/grandkids owing thousands to the IRS).

Rules of the 1031 Exchange

It wouldn’t be the IRS we all know and love if they didn’t impose a few rules on their little tax plan, now would it? And, as you know, when dealing with the IRS, it’s VERY important that you follow all of their rules, because they can make your life absolutely miserable.

Rule #1 - You can only use the 1031 Exchange for assets that are “like-kind.” In other words, you have to exchange real estate for real estate, paintings for paintings, cattle for cattle (yes, you can 1031 Exchange paintings and cattle). You CAN trade real estate types for other real estate types, though, like going from a single-family home to an apartment complex.

Rule #2 - You have to trade up (or equal). The IRS doesn’t want you downgrading assets, so the replacement property value has to be equal or more than your current asset. If it’s not, you’ll have to pay taxes on the difference. For example, if you’re selling a $200,000 property and doing the 1031 Exchange for a new property valued at $175,000, you’ll have to pay taxes on the $25,000 difference. Bear in mind, however, that you can spread the amount over multiple properties. So if you’re exchanging $500,000 worth of asset(s), you could buy one $500,000 property or five $100,000 properties - totally your call on how to spread the exchange.

Rule #3 - You have to identify and buy property within certain timeframes. Once you decide you want to do a 1031 Exchange, you must “officially” identify your replacement property within 45 days of selling the original asset. Thankfully, the IRS allows you to identify more than one potential investment property, which is good in case one falls through.

There’s another countdown you have to be mindful of, as well. Once you sell the original property, you have 180 days to close on the new property. The IRS does not mess around with these timeframes, either, so be sure you can meet them before taking action on the 1031.

Rule #4 - You have to use an intermediary to complete the transaction. You, the investor, are not allowed to touch the money that’s being transferred from one property to another. That money cannot go into your bank account, or your spouse’s, or your employee’s, or your broker, or anyone else who falls on the IRS’s no-no list. Instead, you have to appoint an intermediary to take the funds during the transfer process. There are lots of companies who handle this, so ask around in your network or search online to find a reputable intermediary.

Why You Should Care

There’s only one real reason why you should care about 1031 Exchanges, and that reason is MONEY. By using this tax loophole to your advantage, you can build much more wealth over the course of your investment career than if you were to simply pay taxes on each property you sold. Basically, using a 1031 Exchange allows you to leverage large sums of cash that ultimately belong to the IRS, to your own advantage.

1031 Exchanges can also be used to change up your strategy to something that is more suitable to your needs. Let’s say you’ve spent the last 20 years investing in low-income properties that are fairly high maintenance. Now you’re ready to start taking it a bit easier with some lower maintenance properties, but they’re more expensive. You can use the 1031 Exchange to buy the more expensive, lower maintenance properties and not pay a dime in taxes on the capital gains you’ve earned over the last 20 years.

I won’t go so far as to say the IRS is your friend, but in the case of 1031 Exchanges, they’re definitely helping you out. If you’re ready to trade one investment property for another one, it’s worth considering how this tax strategy might help you in the short and long terms.