You Don’t Need to Be Sophisticated Investor to Use 1031 Exchanges for Property Swaps

One of the most common misconceptions about 1031 exchanges is that they are “tax loopholes” designed to benefit the ultra-wealthy real estate investor or a large real estate developer. This is simply not true.

Tax-deferred exchanges, in one form or another, have been in existence for more than a hundred years to help American taxpayers continue their investments with a reduced tax burden. Section 1031 of the Internal Revenue Code (IRC) provides anyone who uses a property for their business or as investment property with the ability to postpone paying taxes on the financial gain of a sale of a property, as long as they follow certain exchange rules and reinvest the proceeds in a similar “like-kind” property.

According to the IRS, this includes individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity. This is far from a “tax loophole” for only the most sophisticated investors— taxpayers of many shapes, sizes and circumstances can take advantage of a 1031 exchange. This is welcome news for the 36% of Americans who believe that real estate is the best long-term investment they can make, according to Gallup.

Individual Taxpayers Can Use 1031 Exchanges, Too

While most of the IRS’s list of allowable taxpayers comprises different types of companies and businesses, individual taxpayers can also benefit from the tax incentives offered by 1031 exchanges. Essentially, anyone – regardless of wealth or financial sophistication – who owns investment property with a market value greater than its adjusted cost basis can use a 1031 exchange.

Small investors often overlook the possibility of a 1031 exchange because they either aren’t aware of the tax-deferral strategy or assume that these exchanges are limited to substantial commercial properties. However, most property exchanges involve the sale of residential investment properties. These properties are typically held by individual investors and small businesses. Instead of needing to cash out to pay taxes, using a 1031 exchange allows these taxpayers to reinvest their entire sale proceeds, thereby increasing their buying power, expanding their businesses, or diversifying their real estate holdings.

Common Situations When Individuals Can Use 1031 Exchanges

There are a variety of scenarios in which an individual taxpayer can leverage 1031 exchanges to optimize their tax strategy. These may include when individual investors are interested in selling:

• Their vacation or second home, under select circumstances, to buy an investment property, such as rentals, Airbnb, or VRBOs.
• One investment property to buy another investment property with a better ROI, such as upgrading from a single-family residence to a duplex.
• Raw land to purchase a small retail building.
• An outdated property used for a small business, for raw land where the taxpayer can build a property exactly to the business’s specifications and needs.
• A small office building for apartments – or vice versa, especially if individual investors are tired of dealing with late-night calls from residential tenants.
• A single investment property to invest in several properties.
• An inherited rental house to buy another property of equal or higher value as an investment.

To help sell their properties and reach their financial goals in any of the scenarios, individual taxpayers often work with estate attorneys, accountants, and registered investment advisors. To best leverage a 1031 exchange, individual taxpayers should also collaborate with a qualified intermediary to make sure the process is as seamless as possible.

Those Who Can’t Use 1031 Exchanges May Come as a Surprise

Surprisingly, individual taxpayers such as “flippers” who buy and rehabilitate properties quickly for resale, and real estate developers, generally cannot take advantage of IRC 1031. The main reason is that the properties owned by these types of taxpayers are considered inventory or “property held primarily for sale,” which is specifically excluded from receiving tax deferral treatment. 

Additionally, taxpayers who use a second house or vacation home for more than 14 days a year or more than 10% of the days the property was rented out to others (whichever is greater) would also be unable to use a 1031 exchange to purchase a new property. Therefore, it is often safe to assume that a taxpayer who uses a second or vacation home for personal use does not qualify for 1031 exchange treatment.

Finally, if an individual taxpayer is trying to exchange an investment property in the U.S. for a property overseas, the properties are not considered “like-kind” and therefore not permissible under IRC 1031. However, an individual taxpayer who owns property overseas can exchange it, if subject to U.S. capital gains taxes, for other foreign property.

The scenarios in which an individual taxpayer—who is not an ultra-wealthy investor or real estate developer —can leverage 1031 exchanges are vast. By knowing the basic rules, any individual taxpayer with a property used in their business or for investment can easily work with a qualified intermediary to reap the rewards of their investment.