What is a 1031 exchange?

A 1031 exchange is a way to sell and buy real estate while avoiding capital gains taxes. Named after section 1031 of the IRS code, it allows you to sell an investment and buy another similar investment without being taxed on the profits from your sale. It used to be possible to do a 1031 exchange on almost any type of investment, but the Tax Cuts and Jobs Act of 2017 limited it exclusively to real estate.

What is a 1031 exchange?

A 1031 exchange is akin to a like-kind exchange of investment property. IRS rules state that “Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality,” adding that properties are generally of like-kind “regardless of whether they’re improved or unimproved.”

This wording has led many enterprising investors and their tax attorneys to some creative claims, like an office building and raw land that could be the site of a new office building, could be considered like-kind for 1031 exchange purposes.

While the like-kind language allows some room for interpretation, the rest of the rules around 1031 exchanges are “very rigid, and there are plenty of traps for the unwary,” says Stephen Vajtay, a partner in Newark, NJ law firm McCarter & English’s Tax and Employee Benefits practice and professor of law at Seton Hall University School of Law. Case in point: any real estate used as a residence (more on that later).

How does a 1031 exchange work?

When you sell a property and are trying to qualify for a 1031 exchange, you have to use a qualified intermediary in the form of an independent person, company or entity. Your intermediary will receive the proceeds of the sale of the first property.

When that first sale closes, you have 45 days to designate the like-kind property you want to buy in writing to your intermediary. You’ll have 180 days after closing on the old property to actually purchase and close on the new property, with your intermediary paying for the new property directly. If at any point you receive the cash or try to to do it yourself, you don’t qualify.

The tight timeline can be difficult, especially in hot markets where deals are prone to falling through. Meeting the deadlines “can be tough since negotiations are sometimes unpredictable,” says Jeremy Babener, founder of Structured Consulting, a Portland, Ore.-based business consultancy, and a former U.S. Treasury Office of Tax Policy employee.

When executed correctly, the 1031 exchange allows you to avoid capital gains tax until you sell the new property, at which time you can do another 1031 exchange. It’s possible to keep doing 1031 exchanges indefinitely — until your death, in fact. At this point your heirs can “sell the real estate and pocket the cash without significant tax consequences since there would be little or no gain on the sale.” The inherited property would have a stepped-up fair market value tax basis, says Vajtay.

1031 exchanges and different types of real estate

Any property “used by a taxpayer in a trade or business or held for investment” qualifies for 1031 exchanges, says Vajtay. Office buildings, retail spaces, warehouses, raw land, campgrounds, apartment buildings and orchards are all types of commercial properties that can qualify for a 1031 exchange.

You cannot use the 1031 exchange on residential real estate you’ve been using as your primary residence. So forget about trying it if you’re selling your principal home and buying a new one.

Property that you’ve been using as a vacation home or as a second home, on the other hand, could be a different matter. It can qualify for a 1031 exchange as long as you rented it for 14 days or more and stayed in it for 14 days or less for each of the two years preceding the sale.

Why do a 1031 exchange?

A 1031 exchange “can make your current sale tax-free,” and if you keep doing “1031s to defer that gain, you can avoid ever paying income tax” on it, says Babener. Federal long-term capital gains tax can take up to 20 percent of the profit you make from selling your property, so doing everything you can to avoid it is smart business. The 1031 exchange “is one of the very few sections of the tax code that allows for pre-tax reinvestment of the proceeds of a sale,” adds Vajtay.

What are the downsides of 1031 exchanges?

The biggest downside of a 1031 exchange is how difficult it is to execute correctly, especially if you’re a novice. The “45-day clock puts a lot of pressure on [the investor] and gives the new property’s seller a lot of leverage,” says Babener. And then there’s the 180-day timeframe you have to actually purchase the new property. In between the two, even experienced investors can get tripped up. “It’s easy to overlook a rule or miss a deadline, which can cause the real estate sale transaction to become fully taxable,” adds Vajtay.

Other potential pitfalls: not properly accounting for any mortgage refinancings or reimbursements (this can count as taxable cash back if the mortgage on your new property is less than the one on your old property) and any funds going directly through you, instead of the intermediary.

In an ideal world, you’d realize you’d messed up the 1031 exchange immediately, but that’s not always the case. It’s possible to find out you’ve done it wrong years down the line after an audit. Paying penalties and interest to the IRS on a massive real estate gain after you’ve already tied up funds in a new property can be financially ruinous. Make sure you do everything right and have someone qualified checking over your steps and keeping track of the timeline to avoid errors.

Final word

A 1031 exchange is a great idea for any investor who is selling real estate but wants to stay invested in real estate, avoid a big tax bill, and/or plan their estate — as long as they do it correctly. The consequences of an error can be costly.

New investors trying to execute a 1031 exchange for the first time need to seek out as much professional guidance from tax and real estate experts as they can. Even seasoned investors should enlist an outside pair of eyes to make sure they’ve crossed every “i” and dotted every “t”. Or maybe two sets of eyes, just in case.