Summary: In this article, you’ll learn how to do a 1031 exchange with real estate in the year 2023 including the most important rules to follow as a real estate investor and 1031 exchange success stories to inspire you. Note: To improve the experience of this page, we’ve broken out this article into a series of shorter articles that we hope will be much easier to digest than our original “ultimate guide.” You’ll find quick links to these related articles below. We hope you find all of these articles useful for your real estate investing and like-kind exchange strategy!
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Once you start Googling “how to do a 1031 exchange” or “1031 exchange rules” there’s a solid chance that you already have an idea of what a 1031 exchange is and the benefits of doing one, but here’s a quick recap for you anyways.
A 1031 Exchange, also called a Starker Exchange or Like-Kind Exchange, is a powerful tax-deferment strategy used by some of the most financially successful real estate investors. This is, perhaps, even more true in 2023.
Why? Because in many U.S. cities real estate prices have surpassed the “bubble levels” of a decade ago (even amidst COVID-19). Because of this, many investors think that today is the optimal time to exchange properties in expensive markets like California for cash flowing properties across the country.
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What is a 1031 Exchange
Basically, a 1031 exchange allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long another “like-kind property” is purchased with the profit gained by the sale of the first property.
However, there are more benefits to doing a 1031 exchange than just saving yourself from taxes.
These 1031 exchange benefits include:
- The ability to shift your investing strategy by exchanging 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 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 is where one property is literally swapped for another property of like-kind. However, the likelihood that the property you want is owned by someone who wants your property is really, really 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.
In order to do a 1031 exchange successfully, it’s essential that you follow the following rules to a tree. If you fail to comply, you could be on the hook to pay capital gains tax, and nobody wants that.
1031 Exchange Rules for Real Estate Investors
There are 7 primary 1031 Exchange rules, which include:
- The like-kind property rule
- Investment or business purposes only
- Greater or equal value
- Must not receive “boot”
- Same taxpayer
- 45-day identification window
- 180-day purchase window.
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: Like-Kind property is a very broad term which means that both the original and replacement properties must be of the same character or nature, even if they differ in quality.
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.
- Exchanging an apartment building for a duplex would be allowed.
- Exchanging a single-family rental property for a commercial office building would be allowed
- 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 property must be within the U.S. to qualify under section 1031.
**Another fun fact: Starker Exchanges can include more than two properties. For example, you can exchange one property for multiple replacement properties and vice versa: you can exchange multiple properties for one larger or more expensive property. As long as the new properties are like your original properties, you’re good to go. Do yourself a favor and get a good qualified intermediary and replacement property specialist to assist you.
Rule 2: Investment or Business Property Only
A 1031 exchange is only applicable for Investment or business property, not personal property. In other words, you can’t swap one primary residence for another.
- If you moved from California to Georgia, you could not exchange your primary residence in California for another primary residence in Georgia.
- 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.
- 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 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, the new property (or properties) you purchase need to have a net worth of at least 2 million dollars, and you’ll have to carry over at least a $500,000 mortgage.
It’s important to note that the $2,000,000+ value, and $500,000 mortgage, can go towards one apartment building or three different properties with a total value of $2,000,000+. (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”
A Taxpayer Must Not Receive “Boot” in order for the exchange to be completely tax-free. 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 completely okay and often used when a seller wants to make some cash and is willing to pay some 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, you would need to pay the normal capital gains tax on the $500,000 “boot.”
Rule 5: Same Tax Payer
The tax return, and name appearing on the title of the property being sold, must be the same as the tax return and titleholder that buys 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 owned by the LLC, and because Sally Jones is the sole member of the LLC, she can purchase property in her name, and be in compliance with the 1031 code.
Rule 6: 45 Day Identification Window
The property owner has 45 calendar days, post-closing of the first property, to identify up to three potential properties of like-kind. This can be really difficult because the deals still need to make sense from a cash perspective. This is true especially in today’s market because people tend to overprice their properties when there are low-interest rates, so finding all the properties you need can be a challenge.
An exception to this is known as the 200% rule. In this situation, you can identify four or more properties as long as the value of those four combined does not exceed 200% of the value of the property sold.
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 rules and qualification requirements that you must comply with in order to perform a successful 1031 exchange. 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 huge benefit for real estate investors who know which markets are primed to grow next.
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 the biggest disadvantages is 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, if you want to maximize the benefits of your exchange, it’s important that you choose your replacement property (or properties) wisely, investing in a market that has good potential for growth in the future.
A 1031 Exchange Success Story
“We had a house in San Francisco. It was a rental property, and we knew we wanted to sell it. But if we did sell it, we would have to pay a pretty hefty capital gains tax. So, we knew we had to do a 1031 exchange. Do you have any idea how many rules there are? It’s insane. We were looking at making about $1.5 million, but there was no way we could buy “like-kind property” in the Bay area, and actually make a profit. That’s when we heard Kathy Fettke on the radio, and what she was saying sounded too good to be true. It really did.
We were very cautious when we first found RealWealth, so we took our time. But eventually, we trusted them. Their whole ideology is about teaching you how to be a great investor, and it really works. I mean, I’ve learned so much more in the last year or so than I ever knew about rental property before.
It was amazing how much father our money went outside of the Bay Area. I know the old rule of thumb was, “You have to be around your rentals.” But with technology, the internet, and a trustworthy team, this isn’t necessarily true anymore. At least it wasn’t true for us.
The result: We sold the one property in the Bay Area and we turned around and invested in about 20 properties, increasing our cash flow six times.” — Claudia & Julian Fraser
Today Claudia and Julian own over twenty properties in 3 states, and they’re bringing in about $15,000 of net cash flow every month. It all started with a successful like-kind exchange.
Your 1031 Exchange Questions Answered (Video)
After reading this article and/or watching the video above, one big takeaway we want to leave you with is this: everyone has the ability to end up with passive income from real estate – even if you don’t have any money to start with. All you need is a solid education to know how to do use this powerful strategy correctly.
This article is just a basic overview of how to do a 1031 exchange and the rules for doing a 1031 exchange successfully. Hopefully, you now realize how important it is to understand the intricacies of real estate investing, real estate market cycles, and growth opportunities before you even think about getting started. If you’re a beginner, you should start by learning how and where to invest in real estate in 2023. For those of you who are more experienced, take some time to get a solid understanding of 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. Even a small mistake can jeopardize the deferment of your capital gains taxes. This is why most investors seek professional help.