If you’re thinking about selling an investment property, you might be worried about the taxes you’ll have to pay on the profits. That’s where a 1031 exchange comes in. It’s a tax strategy that allows you to sell one property and buy another without paying capital gains taxes right away.
This guide breaks down 1031 exchange benefits in simple terms so you can understand how it works and whether it’s right for you.
What Is a 1031 Exchange?
A 1031 exchange is a way to delay paying taxes when you sell an investment property. Instead of cashing out and paying the IRS, you use the profits from the sale to buy another property. This keeps your money working for you and helps you grow your investment. It’s called a 1031 exchange because it comes from Section 1031 of the IRS tax code.
Why Use a 1031 Exchange?
The biggest benefit is tax deferral. You don’t have to pay capital gains tax on the sale of your property if you reinvest the money into another investment property.
Other reasons people use a 1031 exchange include upgrading to a better property, moving into a new market, consolidating multiple properties into one, diversifying their investments, or stepping away from active property management.
What Kinds of Properties Qualify?
Not all properties are eligible for a 1031 exchange. To qualify, the property must be used for business or investment purposes. That means rental properties, commercial buildings, and land qualify, but your personal home does not.
The new property must also be used for investment or business. The IRS says the properties must be “like-kind,” but that’s a broad term. You can exchange a rental house for an office building or land for an apartment complex, as long as both are held for investment.
The Basic Timeline
Timing is everything in a 1031 exchange. There are two key deadlines. You have 45 days after selling your property to identify your new one. You must identify it in writing and follow the rules. You must close on the new property within 180 days of the sale of your old property. If you miss either deadline, the exchange won’t qualify and you’ll owe taxes on the sale.
How a 1031 Exchange Works
First, you sell your current investment property. Before the sale is complete, you’ll need to set up a Qualified Intermediary, or QI. This is a neutral third party who holds the money from your sale. At closing, the money goes directly to the QI, not to you. If you touch the money, even for a day, the IRS considers the sale taxable.
Next, within 45 days, you must tell the QI what property or properties you plan to buy. This is called the identification period. Then, you have up to 180 days to close on one of the identified properties. The QI uses the funds from your original sale to purchase the new property. If everything is done correctly, you’ve completed a 1031 exchange and deferred your capital gains tax.
What Happens to the Taxes?
The taxes are not gone. They’re just delayed. If you sell the new property in the future without doing another exchange, you’ll have to pay taxes at that time.
But if you keep doing 1031 exchanges, you can keep rolling the gains into new properties. Many investors continue doing this for years, and when they pass away, their heirs get a step-up in cost basis. That means the taxes may never have to be paid at all.
Can You Exchange Into a REIT or Fund?
Not directly. You can’t exchange into shares of a Real Estate Investment Trust (REIT) because REIT shares aren’t considered like-kind property.
However, there are some strategies that allow for a two-step process. You might first do a 1031 exchange into a Delaware Statutory Trust (DST), and later that DST could be absorbed into a REIT through a different kind of exchange called a 721 exchange.
Common Mistakes to Avoid
Missing the 45-day or 180-day deadlines will disqualify the exchange. Taking possession of the money from the sale, even for a short time, will also disqualify it. Not using a Qualified Intermediary is another common error. A real estate agent, accountant, or attorney doesn’t count unless they’re set up to be a QI. Buying a property that doesn’t qualify, such as a vacation home or a property you plan to live in, won’t work for a 1031 exchange. Also, if you don’t reinvest all of the money or take some cash out, that part will be taxed. That cash is called “boot.”
Who Should Consider a 1031 Exchange?
If you own investment property that’s increased in value and you want to reinvest the proceeds into more real estate, a 1031 exchange is worth looking into. It works well for landlords who want to upgrade to larger or better properties, investors who want to move into new markets, business owners selling commercial buildings, and retirees who want to reduce active property management responsibilities.
Families looking to pass real estate on to the next generation often use 1031 exchanges as part of their estate planning.
In Summary
A 1031 exchange is one of the most powerful tools real estate investors can use to grow their wealth while keeping taxes at bay. It allows you to reinvest your profits without giving a big chunk to the IRS.
While the rules may seem a little complex at first, they’re very manageable when you work with the right professionals. That includes a Qualified Intermediary, a knowledgeable real estate agent, and a tax advisor.
With good planning, a 1031 exchange can help you build a stronger portfolio, improve your cash flow, and set yourself up for long-term success in real estate investing.
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