Why real estate investors (and their tax advisors) love a 1031 exchange
Section 1031 is a provision in the tax code that can offer immense value to real estate investors and other real property owners. In a 1031 exchange, you essentially swap one real estate property for another — and by doing so, defer capital gains taxes on the sale of the first property.
Tax advisors often take advantage of this provision as a tool to benefit their clients. If you’re curious how it works and whether a 1031 exchange might be a useful method to advance your own business interests, keep reading to learn more about the process.
What is a 1031 like-kind exchange?
Typically, when you sell any real property, you owe capital gains taxes on the sale. These are due for the tax year in which you sold the property and can often be substantial.
A like-kind exchange is a way to defer that tax burden. By selling a property and then quickly using the proceeds to acquire another property, you can largely defer paying capital gains taxes indefinitely.
1031 exchange rules
To qualify for capital gains deferment via a 1031 exchange, you have to structure the sale process to meet certain specific rules, including but not limited to:
- You must exchange real property for other real property.
- You must identify a new property to acquire within 45 days.
- You must complete the exchange and take possession of your newly acquired property within 180 days.
- Generally, all funds from your real property sale must be held by a qualified intermediary (QI) until the exchange is complete. Think of a QI as performing a function that’s similar to an escrow account.
- You can’t take cash out from the deal by increasing the amount of debt in the new property without possible tax consequences.
You should always plan a 1031 ahead of time. Because you have to satisfy such specific requirements to successfully defer capital gains — including a ticking clock — you don’t want to wait until you’ve already sold your property to begin.
A rushed or unplanned 1031 also means you’re more likely to make a mistake, which could expose you to unexpected tax balances due.
When should you consider using Section 1031?
A 1031 is a powerful tool for property owners to defer capital gains taxes. As long as you have proper counsel from a tax advisor, most 1031s are not particularly complex, and many real estate investors regularly use the provision.
A careful analysis is typically needed to determine the validity of a 1031 exchange. It is important to analyze the cost of the exchange itself as well as how it fits into your own personal tax situation.
For instance, you may have net operating losses (NOLs) or capital losses. In this situation, it may make more sense to utilize those losses rather than invest in property that isn’t the ideal fit.
How do you do a 1031 exchange?
From a high level, the typical 1031 process is fairly straightforward. Here are the key steps:
- Identify an exchange property: Before you sell a real property, look for properties you’d consider exchanging it for. Ideally, you should evaluate multiple properties to give yourself options to choose from before settling on one to buy.
- Meet with your tax advisor: Let your tax advisor know you’re considering a 1031 and run through the specifics of your situation to make sure you proceed correctly in order to satisfy all the requirements needed to defer capital gains.
- Sell your current property: Complete the sale of your existing real property. You’ll use a QI to take and hold all funds from the sale until the exchange process is complete.
- Acquire a new property within 180 days of your sale: Ideally, you’ve already identified a new property to acquire. But if you haven’t, you must do so within 45 days of the sale and complete the acquisition within 180 days.
What about more complex transactions?
Many 1031 transactions follow the basic structure outlined above. However, more complicated situations may necessitate a more nuanced approach here.
For example, let’s say you’re partnered with other investors on a joint investment property that you all want to sell. However, while you want to do a 1031 with the proceeds from your half of the property, one partner wants to cash out.
In this situation, you can’t just proceed with a straightforward 1031. Instead, you’ll need to work with your tax advisor to pursue more intricate deal structures that would allow both you and your partner to achieve your goals for the transaction.
How Wipfli can help
We advise real estate investors on transactions and taxes. Ask our team to help you strengthen your tax strategy and implement tools like 1031s that may defer or reduce your tax exposure. Learn more here.
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