Learn all about one of the most powerful tools for building long term generational wealth
A 1031 tax deferred exchange, or a like-kind exchange, is a powerful opportunity for the real estate investment community to sell a property and defer (not avoid) capital gains taxes and depreciation recapture by purchasing another income-producing property with the proceeds.
Learn all about this valuable tool from the IRS for real estate investors with first-hand insights from our founder and multifamily investment advisor, Joe LaFleur.
What is a 1031 tax deferred exchange?
Per Section 1031 of the U.S. Internal Revenue Code (IRC), a 1031 tax deferred exchange allows investors to postpone paying capital gains taxes and depreciation recapture on a property if the proceeds are reinvested in similar property as part of a qualifying like-kind exchange. 
“A 1031 exchange is insurance that you can find a property that you want to exchange into after you sell yours to defer the taxes,” says Joe. “Instead of having to pay depreciation recapture plus the capital gains taxes, you’re able to use that to purchase another property to generate the same or greater income for you as the owner and investor instead of paying the money to the IRS.”
In this scenario, any type of real estate investment is considered like-kind, not just multifamily. “If you’re selling your apartment building and you’re purchasing a Burger King triple net lease (NNN), it’s like-kind. If you’re selling your mobile home park and purchasing a Delaware statutory trust where you actually have a percentage ownership of a large group of properties, that also fits within the 1031 exchange. If you are selling your apartment building and buying a wonderful piece of land that you’ve always wanted and you’re using it for investment purposes, that also counts in the 1031 exchange,” explains Joe.
How does a 1031 exchange work?
A 1031 exchange begins when you tell your agent you want to undergo one as you are selling your apartment building and getting close to going under contract. Your agent will connect you with a qualified intermediary who will have the necessary paperwork to assist you in properly completing the exchange process.
There are a few different structures of a 1031 exchange, but the most commonly used is the three property structure where you have 45 days from the day of closing to identify up to three properties you want to exchange into.
How does the three property rule structure work?
To conduct a three property structured 1031 exchange, you have 45 days to identify up to three properties you want to purchase, whether you have them under contract or not, from the date the 1031 exchange is enacted.
Experts recommend that you have at least one of the properties under contract and utilize the other two as backups should your ideal property’s contract fall through.
Once your properties have been identified, you have up to 135 days to close on at least one of those properties.
That means you have a total of 180 days to complete your 1031 exchange for equal to or greater than the dollar amount you have just sold.
*Note: Weekends and holidays are not excluded from your exchange period. All weekends and holidays count as part of your 180 days. If your 180 day deadline falls on a Saturday, Sunday, or a holiday, you will not receive an extension.
Are there any caveats to the 1031 exchange?
There are a few different special scenarios that must be carefully considered when conducting a 1031 exchange to ensure it is done properly.
If you do a 1031 exchange and one of the properties you choose to purchase is a vacation home, you would need to keep it as a rental for investment purposes for two years and one day before utilizing it as a proper vacation home to abide by the tax codes.
In a 1031 exchange, you must also consider the exchange equivalent of the debt and equity of the property because you also need to exchange the same debt amount. For example, if you sold a property for $10 million and you had $5 million of debt and you purchased a property for $11 million, you need to have $5 million or greater of debt to cover the complete exchange.
Additionally, if you sell a $10 million property, but only want to buy a property for $9 million and put $1 million dollars in your pocket at closing, that’s perfectly fine, but you will owe the capital gains and depreciation recapture on the $1 million you pocket. The terminology for that process is called boot.
Why is the importance of a qualified intermediary?
A qualified intermediary is an entity that creates documentation supporting a taxpayer’s intent to initiate a IRC Section 1031 tax deferred exchange and holds the exchange proceeds in a manner that preserves principle and liquidity.
“When you close, the money does not go to you. It cannot be touched by you. Qualified intermediates are going to take and hold all of the proceeds from your sale, so it’s important to use a reputable qualified intermediary with a large surety bond to protect your interests because you’re entrusting them with all your funds until you go and buy your exchange property,” says Joe.
How do 1031 exchanges function for inheritance?
One of the other opportunities you have in a 1031 exchange is to set up inheritance for your family.
“If you sell your $10 million property and you go out and purchase 10 properties that each cost $1 million, that can also be covered under the 1031 exchange based on the 200% rule,” details Joe. “Instead of identifying three properties, you buy 10 properties for $1 million each and can give each one of them to your 10 heirs. That way, each loved one has a separate property when you pass away as part of your inheritance instead of battling over the rights to one $10 million property.”
When is it a bad idea to do a 1031 exchange?
You should not complete a 1031 exchange if you:
- Incurred tax losses
- Not interested in purchasing more real estate properties
- Feel taxes are low today and will be higher in the future
“If you have a large loss from something else that occurred in the same tax year or you carried forward losses that the sale of your property offsets, then it doesn’t make sense to do a 1031 exchange,” explains Joe. “Or if you’ve decided you are completely out of the real estate business and you want to exit, pay the taxes, and move on, then you don’t want to do a 1031 exchange.”
Why you should complete a 1031 exchange
Unless you’re in one of the scenarios detailed in the prior point, it’s in your best interest to complete a 1031 exchange as a real estate investor.
There is little to no risk involved in a 1031 exchange—it functions as an insurance policy. “If you cannot find a property after the 45th day, your proceeds stay with your qualified intermediary for 135 more days or until you file and pay your taxes, but at the end of the day, the proceeds go back to you,” says Joe. “You basically get a very cheap insurance policy because maybe in those 45 days, you find a property you really like, and you have the chance to get it while deferring a significant amount of taxes, but if you don’t find a property, you would have had to pay the taxes anyway, so you don’t lose much.”
How we can help with your 1031 exchange
If you need more information on 1031 tax deferred exchanges, explore our resources below:
- Joe LaFleur on 1031 Tax Deferred Exchange
- Interview with Claudia Kiernan from IPX 1031
- 1031 Qualified Intermediary on our Vendors list
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1: Internal Revenue Service (IRS) | Like-Kind Exchanges Under IRC Section 1031