1031 Exchange to Defer Capital Gains Taxes

Ultimate Real Estate Investor Tax Guide »

A 1031 exchange is a method where you can sell one real estate property and buy another using those funds, without having to pay part or all of the capital gains tax on the sale of the original property. The number 1031 refers to section 1031 of the tax code. It’s also known as a “like-kind exchange” of real property.

When you complete a qualified exchange, the tax basis in the original property transfers to the replacement property. That means the capital gains don’t just go away, the tax liability is just deferred until a later date when you eventually sell the replacement property. The only exception would be if you never sell the replacement property. Or you exchange it with another property, repeat as needed, and never sell the final one. That strategy is sometimes referred to as “exchange until you drop.” If your heirs inherit the property after your death, they get the property at a “stepped-up” basis at the fair market value at that time. So in that case, the capital gains taxes from the time you owned it really do never have to be paid.

The deferred capital gains can include depreciation recapture, which is also passed along to the replacement property.

You can sell multiple properties to buy one, or sell one property and buy multiple replacements (“multi-asset exchanges”). And the value of the replacement properties can be more or less than the value of the original property. But if the purchase price of the replacement property is less than the sale price of the original property, the difference will result in a partially taxable transaction (see info “boot” below).

It’s important to know that a 1031 exchange must be declared in writing in advance and specific procedures have to be followed, and you have to use an intermediary to make sure you are never personally are in possession of the funds that are used in the exchange. You can’t sell a property or buy a new one, and then call it a 1031 exchange after the fact. When clients come to us after they have already bought or sold real estate, sometimes they want to know if they qualify for a 1031 exchange, but by that point it’s too late to qualify.

Qualifications

Investment Property vs. Personal Use Property

You can only exchange to/from qualified investment property. You can’t 1031 exchange your home or vacation property. The property must have been used for an income purpose. The property qualifies if it was a rental property, used for your own trade or business, or held for appreciation. You can hold a property strictly for appreciation and not rent it out or use it for a business, and it can qualify for a 1031 exchange, but you can’t claim that a property was held for appreciation if it is also used for personal use, so a vacation home wouldn’t qualify (T.C. Memo. 2007-134). Property that is “held for sale”, such as house that you are flipping, can’t be used for a 1031 exchange.

If the property you are selling was previously used as a home or vacation property, or if the home you are buying is used as a home or vacation property in the future, IRS rev. proc. 2008-16 created a “safe harbor” that the IRS will not challenge if you at least meet the specific guidelines. Essentially, to qualify for the safe harbor, the property you are selling needs to have been a rental property for at least two years, and the property you are buying has to be used as a rental property for at least two years. There is more info on this is our section 121 article.

The Like-kind Test

A 1031 exchange must be for “like-kind” property. There is often some confusion about this qualification, but any type of real estate qualifies as being “like-kind” to any other type of real estate, regardless of whether they are commercial, residential, raw land, etc. One exception is that real estate located in the United States can’t be exchange for a property in another country. Foreign property must be exchanged for another foreign property.

Also, you can’t exchange real estate with interest in a partnership, even if the partnership’s only asset is real estate. So that means you can’t use a 1031 to sell a property and then invest in a real estate partnership deal (such as a syndication). The owner of the new and old property in an exchange must be the same taxpayer. There are ways to do a similar type of investment that can participate in a 1031 exchange if the investment is a Delaware Statutory Trust (more info on that later), or if it is a tenant-in-common (TIC) structure. But those are relatively uncommon.

Related Parties

There are some limitations on exchanges with a “related party.” In this case, that is defined as siblings, half-siblings, spouses, ancestors, descendants, any entity with greater than 50% ownership, the executor or beneficiary of an estate, or if both exchangers are the fiduciary or beneficiary of the same trust. If the exchange is with a related party, then if either party disposes or sells their property from the exchange within two years after the exchange, then the exchange is disqualified. There are exceptions for if a party dies, an involuntary exchange, or if it can otherwise be established it wasn’t done for tax purposes. If it was a related party exchange, you must file form 8824 for the two years following the exchange.

Qualified Intermediary

The tax advantage of the exchange is invalidated if you or another disqualified person accepts the proceeds from the sale of the original property that are used to buy the replacement property. For that reason, you must use a qualified intermediary (QI) to assist with the exchange. The QI should also be an expert on the 1031 process, and they will assist you with meeting all the requirements to successfully complete the exchange. Examples of 1031 intermediaries include Exeter and First American Exchange.

If you are actually just swapping properties with someone (a simultaneous exchange), you could make that exchange without using an intermediary. But that type of exchange is rare, usually the replacement property isn’t coming from the same party that is buying your property.

Time Constraints

There are specific time constraints between when you sell one property and buy the other. Once you sell the original property, you must identify a replacement property or properties in writing within 45 days. You can either identify up to 3 replacement properties, or it can be an unlimited number if the total fair market value of the properties you identify add up to less than 200% of the value of the original property. But there are some exceptions to that, and your 1031 intermediary will assist you with understanding part of the process.

You must complete the purchase of the replacement property within 180 days of when you sold the original property. Note that both time periods start from when you sell the original property, they’re running concurrently (sometimes there is confusion about that). Additionally, if you sold the original property towards the end of a tax year and you haven’t completed the purchase of the replacement property by the due date of your tax return (typically April 15th), you must file an extension, or else you lose the ability to claim the 1031 exchange.

There is also a “reverse exchange” where you can acquire the replacement property before you have completed the sale of the original property. Revenue Procedure 2000-37 defines a safe harbor under which this is possible by using an intermediary to hold (“park”) the acquired property until the original property is sold.

Taxable Compensation (“Boot”)

If you receive any value from the sale of a property that you don’t put into the replacement property, then any excess value that you receive is taxable income called “boot”. In that case, it’s a partial 1031 exchange, and the exchange may relieve you of some tax consequences of the sale, but not all. So the exchange is still valid, but you have to pay taxes on the value of any boot you receive.

The most common way to end up with taxable boot is when the purchase price of the replacement property is less than the sale price of the original property. To avoid boot, your proceeds from the sale (including the pay off your existing mortgage) must be equal or greater than the cost of purchasing in the replacement property (including cash, the new mortgage balance, and transaction costs). And you have to reinvest all the proceeds from the sale (the entire proceeds, not just the profit) into the replacement property.

Boot can include any kind of compensation you receive from the sale of your property that isn’t reinvested in the new one, such as stock, a partnership interest, or debt relief. Debt relief can be taxable when the replacement property mortgage is less than the original property’s mortgage (unless you’re making up the difference by putting in your own additional funds).

Tax Rate on Boot

The tax rate percent on the boot is the same rate as what you would be paying when you sell a property normally. So a portion may be your regular capital gain tax rate, or some or all of it may be taxed up to your ordinary tax rate if it’s attributed to depreciation recapture. If you have suspended passive losses, that may offset some or all of the boot.

Closing Costs From the Sale or Purchase

The sale price that must be reinvested into the new property is the sale price minus certain expenses that are allowed to be subtracted from the sales price. These are the same types of closing costs for the purchased property that you are also allowed to pay for from the exchange funds. The allowable closing costs include:

  • Closing, escrow, and title fees
  • Title insurance that is for the owner (not the lender)
  • Notary, legal, and recording fees
  • Real estate commissions
  • 1031 intermediary fees and exchange costs

Expenses that are not considered allowable closing costs include:

  • Lender fees and any costs related to obtaining the mortgage
  • Title insurance that is for the lender
  • Prepaid expenses such as mortgage interest, insurance, or property taxes
  • Prepaid rent, security deposits, etc.

If 1031 funds are used to pay for these types of costs of the purchased property, that may cause a portion of your transaction to be taxable as boot. To avoid that, you should pay for these costs out of pocket during the closing rather than using the exchange funds.

Exchanging with a DST Investment

Generally, you can only do a 1031 to invest in real estate that you will own yourself. An exception to that is a Delaware Statutory Trust (DST). In 2004, the IRS recognized the DSTs as a valid like-kind investment for a 1031 exchange with real estate. That means you can invest profit from a property into a DST structured investment, which can be a passive real estate investment (similar to a syndication deal). This provides an alternative option if you either don’t want to acquire a new property and prefer a passive investment, or in cases where you are acquiring a property but additionally have left over gains (boot) that you want to invest in order to avoid paying tax on the boot.

Exchanging into a Partnership Investment (721 Exchange)

If you aren’t interested in exchanging to buy another investment property, other than a DST Investment, the other option you have is to exchange your property for an interest in a partnership. This is not a 1031 exchange, it’s actually a different type of exchange called a 721 exchange. This allows you to effectively sell your property to a partnership, and in exchange you get an investment interest in that partnership. The major limitation with this is there aren’t many groups that do 721 exchanges, and you would need to find one that is interested in owning your particular property. But it is another option to consider. An example investment fund that accepts 721 exchanges is Dual City Investments.

Reasons Not to Do a 1031

A 1031 isn’t always the best choice for all situations. Here are some reasons and situations when you may want to not do an exchange:

  • If your income isn’t very high and there isn’t a lot of capital gain, the amount of tax you may owe if you just sell the property may be lower than you might think. For some income levels it can be as low as 0%.
  • Because the basis of the old property is transfered to the new property in an exchange, the lower basis means you’ll have less depreciation to offset rental income in future years than you would have if you just purchased the property without doing an exchange.
  • Many rental properties have suspended passive losses, which is a tax benefit that gets unlocked when you sell a property, but not if you exchange it. In some cases, your tax bill may be less if you sell a property rather than doing an exchange. More on this below.

Suspended Passive Losses

Rental properties often have suspended passive losses. When you do a 1031 exchange, suspended losses in the property(s) you sell get transferred to the replacement property(s). If it was a partial 1031 exchange, and you received some taxable “boot”, then some or all of the suspended losses will be used to offset the taxable boot, and then any remaining suspended losses will transfer to the replacement property.

When you sell the property without using a 1031 exchange, usually the suspended passive losses in that property are “unlocked” and will offset your capital gains in the sale, and then any left over suspended losses can offset your regular (W-2 or business) income. Or if the suspended passive losses in that property aren’t enough to offset the capital gains of the sale, then any suspended passive losses you have in other passive activities (other rental properties) can also go towards offseting that capital gain.

What this means is if you have suspended passive losses that you wouldn’t mind putting to good use, in some cases you might be better off not doing a 1031 exchange and just selling the property without doing a 1031 exchange. It’s a good idea to talk to a tax planner before doing the exchange to make sure it’s a good choice for your situation.

FAQ

Can you exchange a property for a replacement property of lesser value? Yes. But when you don’t reinvest all the funds from the sale of the original property, the leftover funds are taxable income. (See the section on “boot” above.)


This article is part of The Ultimate Real Estate Investor Tax Guide.

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David Orr

I am a credentialed tax professional with a primary focus on tax preparation and advising for real estate investors. Have tax questions or want me to do your taxes? Contact us.

This article was written or updated in 2023 or 2024 and is current for the 2023 and 2024 tax years.

The information presented here is meant for guidance purposes only, and not as personal legal or tax advice.