A Layman Investor’s Guide to the 1031 Exchange

A Layman’s Guide To The 1031 Exchange

 

There are tons of reasons real estate is a great investment class. My favorite reason is leverage, but another huge reason is the tax savings you can achieve. Depreciation is one big way to minimize your taxes.

The other is called the 1031 exchange, an investment/tax strategy that investors have taken advantage of for many decades. In this guide, I will give an overview of the 1031 exchange, explain the ins-and-outs, the pros and cons, and answer a few common questions.

By the end, I hope I will have convinced you that this is a very powerful strategy, and given you enough confidence to be able to look further into this great investor tool.

Disclaimer


A 1031 exchange is a very administratively complicated process. Every situation is unique, and it’s not just a matter of filling out the right tax forms. This post is for informational purposes only and does not provide legal, accounting, or financial advice. I am not a lawyer or accountant. There are legal, financial, and tax implications for every 1031 exchange. Ensure you consult with qualified experts in each of these areas before taking any action.
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What is a 1031 Exchange?

A 1031 exchange is a strategy that real estate investors use to defer (or even avoid) capital gains taxes when they sell their holdings. The strategy consists of trading an investment for a similar investment of higher value. Doing this exempts the investor from paying capital gains tax on the original investment.

Let’s look at a simple example:

  • You buy a house for $10,000
  • A few years later its worth $50,000

If you just sold it, you’d be paying capital gains on the difference ($40,000).

  • You decide to do a 1031 exchange instead
  • You sell the house and simultaneously buy a duplex for $50,000.

The IRS will not tax you on the $40,000 gain from the sale of the first house.

When do I pay taxes on a 1031 exchange?

As alluded to above, a 1031 exchange only lets you defer taxes. It doesn’t get you off the hook entirely, although there are ways to completely avoid taxes, as I’ll explain in a minute.

Doing a 1031 exchange will defer taxes on the investment sale until you sell the final investment. In the example above, when you finally sell the duplex, you’d pay capital gains using $10,000 as the basis. So if you sold the duplex for $100,000, you’d pay capital gains on a $90,000 gain.

The way to never pay capital gains

Using the 1031 exchange strategy, you can defer taxes indefinitely. You defer taxes as long as you continue trading up to larger properties. (Obviously if you just hold onto the properties and never sell you won’t pay capital gains either). The trick is that upon your death, the basis of all your property is reset to the current value of the property. This means you (well, your inheritors really) won’t pay capital gains taxes if they sell the inherited property soon after your death.

Continuing the example above, let’s say you keep trading up:

  • You sell your $100,000 duplex to buy a quadplex.
  • A few years later you sell that for $250,000 to buy a small multifamily.
  • Fast forward, and after doing multiple 1031 exchanges, your $10,000 original investment in the small house has turned into a $5 million apartment complex.

If you sell the apartment complex, you’ll pay capital gains on $4,990,000 (because the initial investment was $10,000).

Ouch!

But if you simply keep the apartment complex until your death, your inheritors can sell it for $5 million and not pay any capital gains taxes. Maybe we should call this the “death” loophole.

Congratulations! You’ve successfully avoided taxes; avoiding death is a bit trickier.

Why is it called a 1031 exchange?

It’s called a 1031 exchange because its described under section 1031 of the IRS code. Although the IRS has modified the 1031 exchange over the years, this strategy is almost as old as the income tax itself. Just 3 years after the United States adopted the income tax, the Revenue Act of 1921 authorized a “like-kind” exchange. In 1954 another amendment expanded upon this and created section 1031.

What does “like-kind” mean?

According to the IRS, properties are “like kind” if they’re “of the same nature or character, even if they differ in grade or quality.” This is a very vague definition, but its also fairly broad.

Real estate is a broad category, so houses, duplexes, apartment buildings, mobile home parks, even gas stations, are all considered “like kind” since they are all real estate.

This means that if you own an investment house, you don’t have to limit yourself to finding a bigger house to trade into.

What the heck is ‘boot’?

When talking about 1031 exchanges, you will often hear people talk about “boot.” This is not a technical term, but a common industry term referring to any “non-like” assets you take out of an exchange. The IRS will tax anything that is “boot.” Therefore, it is in your interest to minimize or eliminate any “boot” involved in a 1031 exchange.

Here are the most common forms of “boot” that you have to be careful to avoid.

  • Cash. The most common form of ‘boot.’ If you sell a property, and keep $10,000 of the profits without reinvesting in a new property, the $10,000 is boot.
  • Loan reduction. If you have a mortgage on the old property of $100,000 but a lower mortgage of $70,000 on the new property, the difference of $30,000 is ‘boot’ and you’ll pay capital gains on this amount.
  • Transaction costs. You cannot pay for transaction costs with the proceeds from the property sale. If you do, this amount is considered ‘boot.’ ALL proceeds must go into the new property. This means you must pay transaction costs from another source.
  • Any other “non-real” property associated with the sale. For example, if you buy a ranch that comes with irrigation equipment, or someone throws in a vehicle with a house purchase. These non-real estate items are considered boot since they are part of the transaction.

1031 Exchange Requirements

There are some very stringent requirements to conduct a 1031 exchange. Obviously, the IRS doesn’t want people to take advantage of this and use it as a loophole for various tax avoidance schemes. Don’t worry though, if you’re a real estate investor, whether professional or amateur, it isn’t that hard to meet the 1031 exchange requirements.

1. The 1031 exchange property must be an investment

First, the properties you’re exchanging must be investments. You can’t do a 1031 exchange to avoid paying capital gains taxes on your house (you usually won’t need to anyway). You also can’t sell an investment property and do a 1031 exchange into a house you plan to live in.

2. You have to be a stepping up into something of more value

Think of doing a 1031 exchange like playing monopoly. You start with a house, then you trade up into a hotel. If your property is worth $100,000, you have to exchange it for a property that’s worth more than $100,000 (if you want to protect all your gains). Technically you could buy a cheaper property, but if you do that, you will pay some capital gains taxes.

3. You need an intermediary to handle the money during the transaction

You must have a qualified intermediary to handle the money during a transaction. That is, once you sell a property, the proceeds will go to this third-party intermediary. That third party will then hold the money until you purchase the exchange property. The IRS does this with lots of things, such as 401k rollovers. Basically, they want to be able to easily track the money trail along the entire transaction.

4. You have to trade for “like kind” property

Some people think that if you sell a house, you must buy a similar house to do a 1031 exchange. This is a myth. In fact, the rules around what are “like kind” are pretty loose. You can sell a house and buy a gas station, apartment complex, or even a piece of land. What you can’t do is sell a house and buy stock, bonds, a piece of art, or collectible figurines.

5. The purchase must be in the same name

If the property is in your name, the exchange property has to be in your name as well. You can’t sell a property that is in your name and buy a new property in your spouse’s name (or a child’s name). This also applies to corporate entities. For example, if your property is in an LLC, that LLC must also be the owner of the exchange property.

This rule also applies to people who have bought a property while single, then gotten married. The previous house will be in the individual’s name, but the new property will be in both spouses’ names. This can be a nasty surprise if not planned for in advance (by putting both spouses’ names on the initial property prior to the 1031 exchange).

6. You must have intent to hold

You must intend for your purchase to be a long-term investment. Unfortunately, there isn’t a concrete requirement but most experts advise that if you hold new property for 2 years or more, you should be fine. This requirement mainly applies to flippers or other investors who only plan to hold a property for a short time.

7. You’re subject to a strict timeline

Finally, the most challenging of all, is that you must adhere to a very strict timeline to conduct a valid 1031 exchange. If you miss any deadlines by even an hour, the entire 1031 exchange will be invalid and you’ll have to pay capital gains taxes. In fact, the next section has all the details on this.

1031 Exchange Timeline

1031 exchange timeline (Photo by rawpixel on Unsplash)The hardest part of doing a 1031 exchange is meeting the strict timeline. Originally, exchanges had to happen concurrently. Then the IRS decided to throw us investors a bone and the “deferred exchange” was born. This allowed investors to sell a property, then look around a while before finding a new property to invest in. Of course, the IRS doesn’t want to give us too much leash, so they’ve outlined some very strict timeline requirements in order to classify as a proper deferred exchange.

If you don’t meet the deadlines, the entire 1031 exchange is invalid, and you’ll have to pay capital gains taxes, even if you did everything else right.

Here is the 1031 exchange timeline:

  • D – Day. Once you sell the first property, the time is ticking.
  • D + 45 Days. You have 45 days to identify up to 3 potential replacement properties. The intermediary must receive the description of the new properties before midnight on the 45th day.
  • D + 180 Days. You have to close on one of the 3 previously identified replacement properties within 6 months (specifically 180 days) of selling the first property.
  • Before April 15. File taxes (or an extension). You must report the exchange to the IRS in the tax year you sell the property. If the 1031 exchange isn’t complete before you file taxes, then you’ll have to file an extension.

The 1031 exchange timeline is the part I hate most about a 1031 exchange. If you’re in a hot market, it’s virtually impossible to identify a suitable replacement property (much less 3) in 45 days. And if the buyer or seller you’re dealing with knows you have this limitation, it can seriously hinder you in negotiations.

Even if you’re not in a hot market, and you’re able to identify three suitable replacements, you can’t change your mind later. If a better deal comes up, or your primary choice falls through, you are stuck with the three options you originally chose.

How to get a 1031 exchange extension

The only way you’re able to extend the 45 day or 180 day deadline is if the President declares a natural disaster in an area that affects you or the properties. In other words, if something terrible happens. In that case, you won’t be worrying about your 1031 exchange anyway. So don’t plan on ever getting an exception to this timeline.

A Few Fine Points on the 1031 exchange timeline

  • Weekends count. If the 45 days or 180 days end on a weekend, you are not granted extra time.
  • You can change your mind anytime before the 45 days is up, but after the 45 day mark, you’re locked in with your three choices.
  • Even though the clock starts when you close on the first property, you can (and should) start looking for a replacement long before you close. In fact, you’d be dumb not too.

1031 Exchange Process

Here are the 10 steps to completing a successful 1031 exchange:

1. Find a qualified intermediary.

Once you’ve decided you want to do a 1031 exchange, start off by finding a qualified intermediary. A qualified intermediary is a neutral, third party that can handle the mechanics of your exchange. A qualified intermediary is necessary to prove to the IRS that you aren’t doing something shady. The IRS is concerned that some people may use this process to avoid taxes in other ways. For example, not using all the money from a sale to purchase a new property. Or trading with a family member using a bogus sales price. So how do you find a qualified intermediary?

You can find a qualified intermediary in a lot of different places. Many lawyers, accountants, even banks can provide these services. There are also companies whose sole offering is to serve as a qualified intermediary. Whoever you choose, make sure they have experience doing 1031 exchanges. I also want to point out that since this intermediary needs to be a 3rd party, you cannot have used them for anything for 2 years prior to the exchange. In other words, you can’t use your regular attorney or accountant to do the exchange.

2. Start looking for a replacement.

Once you’ve interviewed and chosen a qualified intermediary, start looking for a replacement property. Yes, that’s right. Before you even list your current property for sale, you need to start looking for a replacement.

I want to make clear that you don’t need to wait until you find a replacement property to sell your house. But you should start looking and narrowing down your options.

3. List your house to sell.

Next you will list your house to sell. At the very least you will list it just like any other home listing. Talk to your real estate agent about how to describe the property. Many will want to state clearly that this house is being sold for a 1031 exchange. This will ensure buyers are ready to cooperate with your aims. It may also mean you’re limited in your negotiations. Discuss this with your real estate agent to determine which strategy you feel most comfortable with.

4. Sell your house.

Whether or not your property was marketed as a 1031 exchange property, when you finally find a buyer, you’ll need to add certain parts to the contract for a 1031 exchange. The first part is a 1031 Exchange Cooperation Clause. This is a simple section where the buyer agrees to cooperate with you and your intermediary. It doesn’t cost the buyer anything extra, and mainly entails filling out appropriate paperwork during the transaction. Another part you should add is an assignment of contract. This will allow you to assign your intermediary as the entity handling the transaction, so that the money from the sale never enters your hands. There may be other documents required, based on your state, but these are the main ones you should be aware of.

5. Identify replacement properties.

The trickiest part to this 1031 exchange timeline is the identification of a new property to buy.

Here’s how you identify a new property, along with a simple example to illustrate the three options.

Identification rules

Let’s say you sell a house for $100,000.

You have 3 options in identifying replacement property:

1. The 3 Property Option. You are allowed to choose up to 3 properties of any value.

Example:
That means you can pick up to 3 like kind properties with no limit on price. One of the properties might be a $300,000 house. Another might be a $150,000 house. Or another could be a $400,000 duplex.

You don’t HAVE to choose 3 properties, it just gives you more flexibility. What if your primary choice falls through? It happens all the time. It’s good to have 2 other options to fall back to.

2. The 200% Rule. If you choose more than 3 properties, their total value can’t be more than twice the value of the original property.

Example:
You can choose 4 or more properties, but in this example they can’t all add up to more than $200,000 (twice the value of the original property). So one possibility is to choose 4 houses each worth $40,000.

Remember you still need to reinvest the entire $100,000 to shelter it from capital gains, so in this example, you’d have to buy 3 of the $40,000 houses.

3. The 95% rule If you choose more than 3 properties, and their total value IS more than twice the value of the original property, you must buy them all (technically 95% of the total value).

Example:
You choose 4 or more properties, don’t need to worry about value, but you have to buy them all. So you find 4 houses but they add up to $350,000 in value. No problem, but you have to close on all 4.

Although this option gives you more flexibility on what types of properties to identify, you have way more risk that one of them won’t close, scuttling the entire 1031 exchange.

6. Make an offer and sign contract on replacement property.

Once you’ve found a replacement property, you need to make an offer. Like when you sold your initial property, you’ll need to include certain language in the contract to support your 1031 exchange.

7. Normal due diligence.

Do your typical diligence: inspect the structure, check the rent rolls, talk to neighbors, etc. The only difference here is that you lose a lot of negotiating power because you’re trying to do the 1031 exchange. Normally if you find the foundation to be bad you can go back to the seller and renegotiate price. You can do that here, but if the seller knows you’re doing a 1031 exchange, they’ll have all the leverage and can refuse to renegotiate. Then you’re stuck.

8. Close within 180 days.

The next hard deadline after identifying your replacement property is to close within 180 days. Depending on the complexity of the property you’re buying, your time to close may vary, but 180 days is not unreasonable by any standards. Schedule a time to close before the deadline, so if any last-minute complications arise, you can safely postpone the closing without affecting your 1031 exchange.

9. Report to IRS (Form 8824).

After the exchange has been completed, you’ll need to report everything to the IRS with the Form 8824 on your tax return. If you’re doing something like a 1031 exchange, I’m assuming you’re not doing your taxes yourself.

If you are, just stop.

The one thing about reporting to the IRS is that you will report the exchange on the tax return for the year you start the exchange. For example, if you start in November, you might not be done until May of the following year, long after the initial tax filing deadline. So you may need to file an extension while you complete your exchange.

10. Report to state (if applicable).


If your state has income taxes, you’ll need to also report the exchange to your state. The forms and details will vary, be sure to check with your accountant.

Sample 1031 Exchange Calculations

[Note: Throughout this guide I am ignoring a few details in my examples for simplicity. For example, depreciation is applied to the structure, not the land value, which is obviously a part of the purchase price of any property. There are also transaction costs associated with any real estate transaction. When doing a 1031 exchange, you cannot use the proceeds from a sale to pay any of the transaction costs.]

1031 calculations (Photo by Roman Mager on Unsplash)Calculating the gains, losses, deferred taxes and other numbers in a 1031 exchange is incredibly difficult. Like most other tax-related issues, the IRS has spelled out intricate details on every possible situation you might encounter. I will attempt to give a simple overview, but warn you to consult a tax expert before actually trying this at home.

Should I even bother doing a 1031 exchange?

One of the first calculations you want to do is to figure out whether doing a 1031 exchange is even worth it. If your property increases in value by $10,000, is it worth the headache to try to save 15% of that? A lot of people make the deliberate decision that paying $1500 is less painful than doing a 1031 exchange.

However, it’s not as simple as just comparing the sales price to what you bought the property for.

Let me explain. The IRS calculates your gain based on the sales price of the property minus the adjusted basis. In most cases, the adjusted basis is not what you paid for the property.

How to calculate adjusted basis

So how to calculate the adjusted basis? Again, consult a tax attorney for the exact answer, but here are some of the things that affect the basis:

  • Depreciation
  • How you obtained the property
  • Capital improvements
  • And other things, like impact fees, legal fees, zoning costs, costs of extending utilities to the property, insurance reimbursements, easements, postponed gains from previous sale, etc.

This is not an all-inclusive list!

Let’s look at a simple example using the most common adjustments to the basis: depreciation and capital improvements. Let’s say:

Example: How To Calculate Adjusted Basis

  • You buy a house for $100,000.
  • Over the years, you’ve replaced the roof for $10,000 (capital improvement),
  • But you’ve also depreciated the house by $40,000.

To calculate the adjusted basis:

Price paid for home : $100,000 original basis
Decrease to basis    : -$40,000 depreciation
Increase to basis      : +$10,000 capital improvements
Adjusted basis           : $70,000

This means even if you sell the house for $100,000, you’re going to pay capital gains taxes on the difference, $30,000!

That’s lame.

Doing this calculation will help you decide whether you want to do the 1031 exchange or not. For most people, the tax savings are substantial.

What will my basis be in the new property?

Another calculation you should probably do is what your new basis will be.

Why?

One of the benefits of investing in real estate is the tax savings you get from depreciation. But if you do a 1031 exchange, you won’t be able to depreciate the entire amount of the new property.

How to calculate basis in new property

In the previous example, the investor avoids paying capital gains on a $30,000 gain. But this tax will be paid eventually. Thus the $30,000 gain is carried forward to the new property. If the investor pays $200,000 for the new property, s/he can’t depreciate the entire amount. The new basis is the price minus the deferred gain. In other words, the investor can only depreciate $170,000.

Let’s walk through that step-by-step:

  • First calculate adjusted basis of the original house
    • We came up with $70,000 (see example above)
  • Then calculate realized gain
    • This is what you sold the house for minus the adjusted basis
    • $100,000 sales price – $70,000 adjusted basis
    • $30,000 realized gain
  • Then determine deferred gain
    • This is how much of the realized gain you put toward the new house.
    • In this example we’re going to buy a $200,000 and use all the proceeds from the previous house.
      • This prevents us from paying any capital gains taxes
      • So the deferred gain is the same as the realized gain.
    • $30,000 deferred gain
  • Finally, compute your new basis
    • This is what you bought the new house for, minus the deferred gain.
    • In this example we said the new house would be $200,000
    • Subtracting the $30,000 deferred gain, we get
    • $170,000 adjusted basis of new house

Example: How To Calculate Basis in New Property

Sales price of home: $100,000
Adjusted Basis of old house: $70,000
Gain: $100,000 – $70,000 = $30,000
Purchase price of new house: $200,000
Adjusted basis of new house = $200,000 – $30,000 = $170,000

As stated before, this means when you start depreciating this house over 27.5 years, you’ll only be able to depreciate the $170,000 adjusted basis, not the $200,000 purchase price.

Another few points on this example:
      • Since you sold the original house for $100,000, you must pay at least $100,000 for the new house.
      • Since you had a gain of $30,000, you must put down at least $30,000 as a down payment into the new house.
      • If the new house or new payment are less than these amounts, you’ll pay capital gains on the difference.

I’ve used some pretty straightforward examples for demonstration purposes only. Obviously, for your unique situation, you should have a tax expert figure out these numbers for you. This is not a situation in life where you try to save a few bucks by doing it yourself!

Like I mentioned, these are simple examples. There are lots of other situations that will affect these numbers, including:

  • Inheritance
  • Bargain sales
  • Property used partly for business
  • Abandoned property
  • Cancelled debt
  • Foreclosures
  • Involuntary conversion
  • Condemnation

    I cannot stress this enough: don’t try this at home! Get an expert to help you out. Not only will it mean more money saved and peace of mind, it will keep you out of trouble with the IRS.

1031 Exchange Rules in 2018 and Beyond

In 2017, Congress passed (and President Trump signed) the Tax Cuts and Jobs Act of 2017. For most people, this wasn’t promoted as much more than a simple tax cut, but it was actually fairly comprehensive and is often credited for lengthening the post-2008 recovery. For purposes of this article, let’s discuss how it affected 1031 exchanges.

Section 1031 of the IRS code used to refer to all kinds of property exchanges, not just real estate. All kinds of things were exchanged, including farm equipment, stocks, bonds, even Major League Baseball players!

Before the law was passed, many investors feared the 1031 exchange was going to be completely eliminated, as Congress made its intentions clear that the 1031 was being looked at. In the end, the changes to section 1031 were significant, but didn’t apply to real property.

That means none of the changes in the 2017 law will impact your ability as a real estate investor to defer taxes using 1031 exchange rules.

Even though there was speculation that Congress was going to completely repeal the 1031 exchange, I believe it will remain in our tax code for many years to come, possibly forever in some form. Not only are most members of Congress real estate investors themselves, most see a healthy real estate market as foundational to our market economy. Law changes that have drastically impacted real estate values have been few and far between.

Reverse 1031 Exchange

Something people often ask is whether the timeline and process can deviate from what I outlined above. Are there any ways around this strict process?

The main way to do this is the reverse 1031 exchange, which was created by the IRS in 2000.

What is a reverse 1031 exchange?

In short, a reverse 1031 exchange is doing the process backwards. The investor buys a replacement property first, then sells the relinquished property. The timeline is similar, just in reverse: the investor has 45 days to identify the relinquished property, and 180 days to complete the sale.

Investors still need a qualified intermediary to do a reverse 1031 exchange, because they can’t actually take possession of the new property until the old one is sold. So in the meantime, the intermediary must be the owner of the property.

Obviously, this has implications on income and cash flow. First, it goes without saying that the investor will be buying the new property without the benefit of any proceeds which will come through selling the old property.

It will also be more difficult to make loan payments. While the intermediary owns the property, the investor is potentially paying mortgage payments, and not able to use any rents from the property to pay for the mortgage. It’s also complicated if the investor wants to make any repairs or upgrades to the new property.

This is usually addressed by having the intermediary lease back the new property to the investor. So technically an intermediary is the owner and landlord of the property, while the investor is a tenant. The investor then would sublease the property to another tenant and operate the new property.

As you can see, this is complicated.

Why consider a reverse 1031 exchange?

The main reason most people do a reverse 1031 exchange is so that they aren’t pressured to find a new property within 45 days of selling the old property. This is a strict timeline and missing it by mere hours will nullify the entire process and cost a ton in taxes.

As the deadline approaches, you will get nervous and almost desperate to find a new property. You will be tempted to overpay. After all, if you overpay by $10,000 to save $20,000, you’re still better off, right?

Not an optimal solution. Finding the new property first will avoid this problem and allow you to capture the entire tax savings by not overpaying for a property.

What are the disadvantages of a reverse 1031 exchange?


The downside is that reverse 1031 exchanges are administratively complicated and require cash up front. In addition, intermediaries usually charge a lot more to do a reverse 1031 exchange. You will have to consider these costs when deciding whether to attempt a reverse 1031 exchange.

Pros and Cons of Doing a 1031 Exchange

Now that we have a detailed understanding of what a 1031 exchange is and how it works, let’s look at the main pros and cons:

Pros of a 1031 exchange

      • Defer paying taxes

The entire purpose of the 1031 exchange is to defer paying taxes. Though this isn’t necessarily more money in your pocket (since it has to be reinvested to be eligible), it does mean you are able to grow your wealth much faster than if you paid capital gains taxes.

      • Can eliminate taxes if done indefinitely

Done smartly, an investor can completely eliminate taxes by holding onto the property until death. At that time, the tax basis of all property will be reset, allowing heirs to sell the property for the full amount without paying any capital gains at all. If that doesn’t make you Rest In Peace, I’m not sure what will.

Another way to eliminate capital gains taxes is to move into the new property, live in it for over 5 years, then sell it. Homesteads can be sold with no capital gains paid on the first $500,000 in gains (for a married couple). This is a complicated maneuver so talk to an expert before attempting this option.

Cons of a 1031 exchange

      • Still have to pay taxes eventually

Unless you hold onto the property forever, the IRS will get theirs. When the day finally comes, 10-,20-, or 50 years from now, you will pay taxes on all the gains you’ve been deferring.

      • Strict timeline and requirements

Not only are you extremely limited in how fast you have to identify and buy a new property, you are limited in what you can buy. You can’t sell your house and buy stock, even if it might be a better investment.

      • Hard to find replacement property

In many markets it might be almost impossible to find a replacement property that will give you a comparable return. This wouldn’t be so bad if you weren’t given only 45 days to do it.

      • Reduced basis in new property (from depreciation)

You won’t be able to depreciate the new property as much as if you’d bought it outright. Since you’re applying deferred gains to the new property, its basis for depreciation will be lower.

      • Legislative uncertainty.

There’s no way to know if the 1031 exchange will exist forever as part of the tax code. What happens if it’s removed? Again, impossible to predict.

There’s also no way to predict future tax rates. Maybe tax rates will be higher in the future, maybe not. Deferring capital gains for 50 years just to pay a much higher rate in the gains is a kick in the teeth.

Many websites list things like building equity, exposure to new markets, and accumulating larger properties as pros of doing a 1031 exchange. I have not listed these things, since you don’t need to do a 1031 exchange to achieve these things. Sure, your wealth will grow faster if you’re able to defer paying taxes, but you can still reinvest your money to achieve these things, albeit in a smaller amount.

Therefore, the main benefit to doing a 1031 exchange is to avoid paying capital gains taxes upon the sale of a real estate property. There are lots of downsides, and since every situation is unique, you should consult with your financial and tax advisors to decide whether the pros outweigh the cons.
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Frequently Asked Questions About the 1031 Exchange

1031 exchange FAQ (Photo by Camylla Battani on Unsplash)Can I use a 1031 exchange to flip properties?

No. 1031 exchanges are meant to encourage long-term investments. Obviously, if you’re doing 1031 exchanges you’re eventually selling your investments, but you must intend to hold onto the property for the long-term. Most experts will advise you to hold onto the property for at least 2 years to be safe.

Can my realtor/lawyer/accountant do the 1031 exchange for me?

You should consult all of those experts, but they cannot serve as your qualified intermediary. You need a neutral, third-party to do this; they can’t be related to you or work for you in any way. In fact, you can’t have done business with them anytime in the past 2 years.

Can I reduce the amount of debt I have?

In addition to “upgrading” the investment by buying a new property of higher value, you must also “upgrade” your debt. If you decrease the amount of debt you have when you upgrade, that reduced debt will be considered ‘boot’ and will be taxed.

Can I do a 1031 exchange on my vacation home?

In some situations, yes. It depends on how long you stay in the house each year and several other factors. Consult your legal and tax advisors to see if your vacation home is eligible.

How much does it cost to do a 1031 exchange?

There are many companies and qualified individuals that can serve as qualified intermediaries. Most of them charge less than $1000 to do a simple exchange. A reverse 1031 exchange may cost between $3500-$5000.

Can I exchange my U.S. investment for a foreign investment?

No. The definition of “like kind” real estate is fairly broad. For example, you can trade a house for a gas station. Unfortunately, based on the U.S. tax code, a house in the U.S. and a house in Germany are not considered “like kind.” Stupid but true.

Do I need a special contract when I buy or sell?

You don’t technically need specific language or a specific contract when you are selling the old property or buying a new property. But it is better to include language about your intentions and expectations of the other party so that you don’t somehow get screwed at the last minute by an uncooperative buyer or seller.

Should you overpay to buy a new property?

Theoretically, yes. If you’re going to save $20,000 in taxes, that is the amount you should be willing to overpay for a property and break even. This doesn’t account for losing the ability to fulling depreciate the new property, the cost of the 1031 exchange, and other factors, but you get the point. Eliminating the risk of overpaying for a property is why many people choose to pay more to do a reverse 1031 exchange.