1031 Exchange Rules & Success Stories for Real Estate Investors

A 1031 exchange is a great way to build wealth with the investment properties already in your real estate portfolio. However, the key to success with this strategy is to thoroughly understand the 1031 exchange rules. To help you, we’ve gathered the most important rules to follow as a real estate investor. Plus, you’ll find some 1031 exchange success stories to inspire your real estate investing journey.

In this article, we break down:

• The benefits of a 1031 exchange
• The critical 1031 exchange rules to follow
• Successfully executing a 1031 exchange to grow your portfolio

What is a 1031 Exchange?

A 1031 Exchange, also known as a Starker Exchange or Like-Kind Exchange, is a powerful tax-deferred strategy utilized by some of the most financially successful real estate investors.

A 1031 exchange in real estate allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long as another “like-kind property” is purchased with the profit gained by the sale of the first property.

However, there are additional benefits to doing a 1031 exchange beyond simply saving on taxes, such as the ability to adjust your investment strategy. 

These 1031 exchange benefits include:

• The ability to exchange high-maintenance properties for lower-maintenance properties without incurring a huge tax liability.
• The possibility of increasing your appreciation potential by exchanging high-priced properties in bubble markets, like Manhattan or San Francisco, for more affordable markets that are on the rise.
• The potential to get out of tenant-friendly markets and reinvest in areas where it’s easier to evict problem tenants and raise rents to market value when the unit goes vacant (ie, areas without strict rent control laws).
• And so much more!

How To Do a 1031 Exchange

Traditionally, a 1031 exchange involves swapping one property for another of like-kind. However, the likelihood that the property you want is owned by someone who wants your property in return is unlikely. This is why the vast majority of 1031 exchanges are delayed exchanges, also known as three-party exchanges. In a delayed exchange, you need a middleman known as a Qualified Intermediary who holds onto the cash from the “sale” of your property and uses it to “buy” the replacement property for you.

To conduct a 1031 exchange successfully, you must follow the rules to the letter. If you fail to comply, you could be liable for paying capital gains tax, and no investor wants that.

1031 Exchange Rules for Real Estate Investors

Rule 1: Like-Kind Property

To qualify as a 1031 exchange, the property being sold and the property being acquired must be “like-kind.”

Like-Kind Property Definition: A like-kind property is a broad term that refers to both the original and replacement properties being of the same character or nature, even if they differ in quality or value. 

In other words, you can’t exchange farming equipment for an apartment building because they’re not the same asset. In terms of real estate, you can exchange almost any type of property, as long as it’s not personal property.

For example:

1. Exchanging an apartment building for a duplex would be allowed.
2. Exchanging a single-family rental property for a commercial office building would be allowed
3. Exchanging a rental property or vacation rental for a restaurant space would be allowed.

EXCEPTION: It’s important to note that the original and replacement properties must be within the U.S. to qualify under section 1031.

Rule 2: Investment or Business Property Only

A 1031 exchange rules dictate that this strategy is only applicable for investment or business property, not personal property. In other words, you can’t swap one primary residence for another.

For example:

1. If you moved from California to Georgia, you could not exchange your primary residence in California for another primary residence in Georgia.
2. If you were to get married and move into the home of your partner, you could not exchange your current primary residence for a vacation property.
3. If you were to own a single-family rental property in Idaho, you could exchange it for a commercial rental property in Texas.

Rule 3: Greater or Equal Value

In order to completely avoid paying any taxes upon the sale of your property, the IRS requires that the net market value and equity of the property purchased must be the same as, or greater than, the property sold. Otherwise, you will not be able to defer 100% of the tax.

For example, let’s say you have a property worth $2,000,000 and a mortgage of $500,000. To receive the full benefit of the 1031 exchange, the new property (or properties) you purchase need to have a net worth of at least $2 million, and you’ll have to carry over at least a $500,000 mortgage.

It’s essential to note that the $2,000,000+ value and $500,000 mortgage can be applied towards one apartment building or three different properties with a total value of $ 2,000,000 or more. (FYI: Acquisition costs, such as inspections and broker fees, also apply toward the total cost of the new property.)

Rule 4: Must Not Receive “Boot”

For the exchange to be completely tax-free, a taxpayer must not receive “boot.” Any boot received is taxable to the extent of the gain realized on the exchange. In other words, you can carry out a partial 1031 exchange, in which the new property is of lesser value, but this will not be 100% tax-free. The difference is called “boot,” which is the amount you will have to pay capital gains taxes on. This option is entirely acceptable and is often used when a seller wants to generate some income and is willing to pay taxes to do so.

An example of this would be if your original property is sold for $2,000,000 and the property you wish to exchange under Section 1031 is worth $1,500,000; in this case, you would need to pay the normal capital gains tax on the $500,000 “boot.”

Rule 5: Same Taxpayer

Another 1031 exchange rule is that the tax return and name appearing on the title of the property being sold must match the tax return and titleholder of the new property. However, an exception to this rule occurs in the case of a single-member limited liability company (“smllc”), which is considered a pass-through to the member. Therefore, the smllc may sell the original property, and that sole member may purchase the new property in their individual name.

For example, the single member of “Sally Jones LLC” is Sally Jones. The LLC can sell the property it owns, and because Sally Jones is the sole member of the LLC, she can purchase property in her name and remain compliant with the 1031 code.

Rule 6: 45-Day Identification Window

The property owner has 45 calendar days, following the closing of the first property, to identify up to three potential properties of like-kind. This can be particularly challenging because the deals still need to make sense from a cash perspective, and depending on investment levels and current interest rates, this can be a difficult task.

Rule 7: 180-Day Purchase Window

It’s necessary that the replacement property is received and the exchange completed no later than 180 days after the sale of the exchanged property, OR the due date of the income tax return (with extensions) for the tax year in which the relinquished property was sold, whichever is earlier.

1031 Exchange Rules: A Recap

As you might realize, there are many 1031 exchange rules and qualification requirements that you must comply with in order to perform a successful 1031 exchange in real estate. To sum things up, the biggest advantage of using this strategy is that you can avoid having to pay capital gains taxes on the sale of an investment property. 

This can be a significant benefit for real estate investors who know which markets are poised for growth in the future. 

It can also be a huge downfall for beginner investors or those who don’t understand the changing real estate landscape. If you don’t, you risk falling victim to one of the most significant disadvantages: the reduced basis for depreciation on the replacement property.

This means that if you were to sell your replacement property, even at a deficit, you would still be accountable for the capital gains on the initial property. In other words, to maximize the benefits of your exchange, it’s essential to choose your replacement property (or properties) wisely, investing in a market with good potential for future growth.

More About 1031 Exchanges (Video)

Next steps

This article provides an overview of how to conduct a 1031 exchange, as well as the basic rules for using this strategy successfully.  Hopefully, you now understand the importance of comprehending the intricacies of real estate investing, real estate market cycles, and growth opportunities before you even consider getting started.

If you are new to real estate investing, start by learning about the best places to buy rental property. For experienced investors, take the time to gain a solid understanding of 1031 exchange rules and regulations. You’ll need to know them like the back of your hand, or you still might end up with a huge tax bill.

Truth be told, a 1031 tax-deferment is incredibly complicated, even if you’re a career investor. A small mistake can jeopardize the deferment of your capital gains taxes. This is why most investors seek professional help.

How Can RealWealth Help You Find 1031 Exchange Replacement Properties?

At RealWealth, we help our members connect with trusted 1031 exchange facilitators and find replacement properties for as little as $150,000 in top national markets. Membership is 100% free, and once you’ve joined, you can schedule a complimentary strategy session with your investment counselor and start viewing sample properties. Become a RealWealth member today!