How Does a 1031 Exchange Work?

A 1031 exchange is a process used in real estate in which one investment property is swapped for another. Through this process, capital gains taxes—which are taxes incurred when an investment is sold—are deferred. 

The term is derived from IRS code Section 1031. It is often used by realtors, investors, title companies, and everyday property owners. The 1031 exchange has several moving parts that must be understood prior to use, including a few primary factors:

• The exchange can only be made with similar properties. 
• There are limits to use with vacation properties.
• There are tax implications and time frames that can prove to be problematic if not met.

Are you still wondering, “How does a 1031 exchange work?” This blog post outlines some of the key considerations prior to use. 

What is a 1031 exchange?

Also referred to by some parties as a like-kind exchange, a 1031 exchange is essentially a swap of one investment property for another of a similar kind. If the properties meet the requirements of Section 1031, owners have no tax or limited tax due at the time of the exchange. 

This exchange essentially allows you to change the form of your investment without cashing out, which would be recognized as a capital gain. This also allows your investment to continue growing tax-deferred. 

Another benefit is that there is no limit to the number of times you do a 1031 exchange. The gain can be rolled over from one piece of investment property to another, and while you might profit on each swap, you still avoid taxes until the property is sold for cash later down the line. By that point, you will only need to pay one tax, which will be at a long-term capital gains rate.

What does “like-kind” mean?

Like-kind tends to have a fairly ambiguous definition and can often change based on the situation. For example, there are cases in which owners can exchange an apartment building for raw land, or a strip mall for a ranch. One business property can be exchanged for another.

While the rules are certainly liberal, the 1031 exchange is applicable only for investment and business properties. The rules can apply to former primary residencies, but certain conditions exist. The same applies to swapping vacation homes if the property is used primarily as a rental property. 

Who qualifies?

Any person who owns property for investment purposes can qualify for a 1031 exchange. The property types included in this exchange include apartment buildings, vacant lots, commercial buildings, and single-family homes. 

What are the benefits of a 1031 exchange?

The primary benefits of conducting a 1031 exchange rather than selling one property and buying another is the tax deferral, which allows you to have more access to capital for investment in the new property. 

As an investor, there are a number of reasons to consider a 1031 exchange, including: 

• You have identified a property with better prospects on ROI.
• You want to diversify your assets.
• As an owner of investment property, you want managed property rather than managing it yourself.
• You want to consolidate several properties or divide a single property into multiple assets.

Keep in mind that a 1031 exchange might require a higher minimum investment and holding time, which can make these transactions more ideal for higher net worth individuals. Due to the complexity of 1031 exchange transactions, you should consult your accountant to see if it is right for your situation. 

What are the different kinds of 1031 exchanges? 

The three main types of 1031 exchanges that investors can choose to execute include the following: 

1. Simultaneous exchange

This is defined as an exchange that occurs when the current property and relinquished property close sales on the same day. Generally, a simultaneous exchange occurs when:

• Two parties exchange deeds.
• A third party facilitates the transaction simultaneously.
• A qualified intermediary handles the exchange. 

2. Delayed exchange

The most common type of exchange, the delayed exchange occurs when the exchanger relinquishes the original property prior to acquiring the replacement property. 

The investor must execute a sale and purchase agreement before the delayed exchange begins. From there, a third-party intermediary initiates the sale of the relinquished property and holds the proceeds from the sale, which remain in a trust for up to 180 days. In that time, the seller must find a suitable property. 

Within 45 days, the investor must identify the new rental property. Within 180 days, the sale must be complete. The extended timeframe is one of the major benefits to the delayed 1031 exchange. 

3. Reverse exchange

A reverse exchange occurs when the replacement property is purchased prior to selling the property that is already owned. Reverse exchanges are less common because cash is required for the purchase, and banks will not usually offer loans for this type of exchange. Investors must identify the relinquished property within 45 days and complete the sale of the exchanged property within 180 days. 

Pursue guidance on financial lending. 

Now that we’ve answered the question “How does a 1031 exchange work?” it’s time to partner with a financial institution that can guide you through the exchange process. By working with an advisor at one of Crews Banking Corporation’s branches, you can pursue guidance on financial lending to ensure you get the most out of your investments.

Important disclosure: The information provided in this material is intended for educational purposes and is not intended to provide specific advice or recommendations for any individual. Crews Banking Corporation, its affiliates, and representatives are unable to provide tax advice. All loans are subject to credit approval.