The Complete 1031 Exchange Guide

Investing in real estate is a great way to diversify your portfolio. But there may come a time when the property you originally invested in no longer suits your needs. When this happens, the first thought is to sell the property and use the proceeds to buy a new one. However, under normal circumstances, that sale can force you to pay capital gains taxes which can eat into your bottom line. Using a 1031 exchange may help you defer capital gains taxes without forcing you to pass up a good deal.

Let’s take a closer look at what 1031 exchanges are, how they work, and the key rules you need to be aware of before trying to initiate one.

What Is a 1031 Exchange?

A 1031 exchange, often called a 1031 like-kind exchange, is a type of real estate transaction that allows you to sell a piece of real property and buy a new one of equal or greater value while deferring the capital gains taxes you’d owe on the sale of your original property. Under normal real estate investment sales, selling properties you’ve owned for 12 months or less will trigger a short-term capital gains tax. The profits you make from these sales will be taxed at the same rate as your regular income. For 2024, that rate can range from 10% to 37%.

But with a 1031 exchange, you’re able to let your investment grow on a tax-deferred basis. While you’re still technically selling the original property, you’re immediately buying one of equal or greater value. This lets you swap the tax assessment from the original property to the new one. As long as you hold onto the new property for at least a year, you’ll avoid the short-term capital gains tax when you sell. Instead, you’ll likely qualify for a long-term capital gains tax on the sale. The current long-term capital gains tax ranges from 0% to 20% depending on your income, so you could end up saving thousands.

What Counts as a Like-Kind Property?

For a 1031 exchange to be a viable option, you must be able to prove that the swap is for a like-kind property. A good way to remember it is that you’ll need to swap real property held for investment for real property of a similar nature.

If you’re planning on selling a home you’ve rented to tenants so you can purchase a strip mall, the transaction will qualify for a 1031 exchange. But if you’re trying to sell your vacation home, you won’t be able to use a 1031 exchange to secure a rental property or a new vacation home. Both properties must be investment properties to be eligible for the exchange.

How 1031 Exchanges Work

Completing a 1031 exchange takes a bit of legwork. Here are the main steps you’ll need to follow to complete the process.

1. Choose Your Properties

You’ll need to choose the investment property you want to sell and find a property you want to buy. Remember, the property you’re buying must have a value equal to or greater than the one you’re selling. You won’t be able to defer all your capital gains if buying a property that has a lower value.

That’s not to say that you can’t purchase a property with a lower value. You can. But you’ll likely have to pay some or all of the capital gains tax on that sale.

Consider your priorities and the types of properties you’re interested in owning. For example, if you currently own a large piece of undeveloped land, you may be able to increase your cash flow by purchasing a fully leased office complex. Or if you’re tired of taking care of routine maintenance on several single-family rental homes, you may choose to buy an apartment complex with an established maintenance team in place.

2. Find an Exchange Facilitator

An exchange facilitator, often referred to as a qualified intermediary, is an individual who helps oversee the exchange. They’ll work with your tax specialist and your attorney to ensure that the exchange goes smoothly. Choose an intermediary who has experience helping investors like you leverage their positions and reduce their tax liabilities.

At First American Exchange Company, our team is familiar with all types of 1031 exchanges and can guide you through the process from beginning to end. You’ll gain access to expert guidance and can rest assured that your exchange will be completed as smoothly as possible.

3. Notify the IRS

You’ll need to notify the IRS of your 1031 exchange. The IRS requires you to fill out form 8824 which provides details about the transaction. You’ll also need to provide the IRS with information about who was involved in the transaction, the amount you sold your original property for, the amount you paid for the new property, and the timeline of the exchange. Your tax advisor will be able to help you through the process.

It’s important that all information gets entered into the form correctly. Even minor errors or misspellings can create delays, causing your exchange to take longer than it should. You’ll need to file this form according to the IRS’s instructions when you file taxes for the year you exchanged the property as well as the next two years following the exchange.

The Common Types of 1031 Exchanges

Though all 1031 exchanges aim to save you money on tax liability, they function in different ways. This can make choosing the right type of exchange for your situation a bit more difficult. Here are some of the most common types of 1031 exchanges to familiarize yourself with so you can make the best choice for your situation.

Simultaneous exchange: With a simultaneous exchange, both the property you’re buying and the one you’re selling close at the same time.
Delayed exchange: Delayed exchanges are the most common and are considered the most flexible since you’re able to choose a property after you’ve successfully sold your other investment property. These exchanges are a great choice when the market is slow or for property investors who have a buyer but haven’t found a great replacement property at the time of the offer.
Reverse exchange: These exchanges are effectively the opposite of delayed exchanges. You close on your new property before selling your original investment property. Reverse exchanges can be great options for buyers looking to purchase property in a hot or in-demand market.
Construction or improvement exchange: Construction exchanges allow you to purchase property and pay for new construction with the profits from the sale of your original property. Any construction or improvements to the property must be made within 180 days of closing for their value to be included in the exchange.

Keep in mind that these are just the most common forms of exchanges. If you have questions or aren’t sure which type of exchange is best for your investment strategy, speak with your exchange facilitator.

The 1031 Exchange Timeline

No matter what type of 1031 exchange you choose, you’ll need to satisfy the timeline for closing on your new property. The full timeline for each exchange lasts for 180 days, but you must identify the properties you want to purchase within 45 days of initiating the exchange to qualify.

Timeline for a Delayed Exchange

If you’re pursuing a delayed exchange, you have 45 days from the date of the sale of your property to find a new property to complete the exchange. You must then close on the purchase no later than 180 days from the sale of your original property. Failure to meet these deadlines results in higher tax liability, as the IRS would require you to pay capital gains tax when you file your tax return for the year.

Timeline for a Reverse Exchange

If you’re pursuing a reverse exchange, you have 45 days from the date of the purchase of your new property to choose a property to sell. Then, you have 180 days to close on that sale and complete the exchange.

Just as with delayed exchanges, failure to meet these deadlines in a reverse exchange could lead to a greater tax liability for the year the exchange was supposed to be complete. However, if you never sell the relinquished property, you will not have capital gains taxes to pay, and the replacement property will be considered purchased outright, with no carryover of tax basis from the relinquished property.

The Benefits of Using a 1031 Exchange for Your Real Estate Transaction

There are several key advantages of 1031 exchanges that real estate investors can use to further strengthen their positions and improve their portfolios. This includes but is not limited to the following:

Stronger down payments: Instead of paying a large chunk of the profits from the sale of your property to the IRS, you’re able to use that money toward the purchase of your new property. This can increase your down payment and make your offer look stronger.
Better diversification: 1031 exchanges aren’t limited to a geographic area. You’re able to sell one property in one state and purchase one in another, helping you diversify your portfolio and potentially strengthen your investments.
Opportunity to increase cash flow: You can sell a property that doesn’t earn revenue, like a vacant piece of land, and use a 1031 exchange to purchase an income-generating property like an apartment building. This could increase your cash flow and help you grow your real estate investment business.

Keep in mind that this list is far from comprehensive. You may see additional benefits that could help you better grow your investment portfolio and increase potential returns.

1031 Exchange FAQs

Here are a few frequently asked questions about 1031 exchanges to help you better understand your options and the implications of this tax-deferral strategy.

Are 1031 exchanges allowed for properties that have lower values?

For a 1031 exchange to fully defer all capital gains, you must purchase a property that has an equal or greater value to the one you’re selling. If the property you’re interested in has a lower value, you may still have some tax liability when the exchange is complete.

What types of properties qualify for a 1031 exchange?

1031 exchanges can be used for investment properties. This includes properties like:

Strip malls
Apartment buildings
Office buildings
Rental homes

As long as the property you’re purchasing is an investment property and not a personal property, it will typically qualify for a 1031 exchange. If you’re not sure if a property qualifies, speak to an experienced exchange facilitator. They’ll help you determine if an exchange is possible and can help you figure out your next best steps.

When can I not use a 1031 exchange in a real estate transaction?

You’re not permitted to use a 1031 exchange in real estate transactions for primary residences, vacation properties that you intend to occupy for more than 14 days per year, or many fix-and-flip properties.

Are the 45-day and 180-day rules set in stone?

The IRS does not allow extensions even if you’re having trouble finding a replacement property. However, they will offer extensions for investors impacted by federally declared natural disasters and emergencies under Revenue Procedure 2018-58.

1031 Exchanges Can Save You Money

Using a 1031 exchange as part of your real estate investment strategy could help you reduce your tax liability by deferring your capital gains taxes over time. But to complete your exchange, you’ll want to have an expert who can guide you through the process.

At First American Exchange Company, our team is here to help. Reach out to our experts with any questions you have and get the guidance you need to complete your exchange with confidence.