2023 Comprehensive Guide to 1031 Exchange
We've collated everything you need to know about the 1031 Exchange in 2023 into one comprehensive guide.
The 1031 Exchange is one of the most powerful tax strategies in real estate. (It scored #1 in our YouTube video on 5 tax strategies for real estate investors!)
It allows you to defer your costly capital gain taxes for years and years into the future. Sometimes, until you die!
In this blog, we’re going to cover everything you need to know about the 1031 Exchange, including filing requirements, the various types of exchanges, rules for qualifying, where to get help, and more.
Let’s dive in.
The IRS allows California investors to sell rental properties, business properties, and land that was purchased for investment purposes and defer all capital gains taxes via IRC Section 1031.
The 1031 Exchange is a tax deferral strategy used by many successful real estate investors. It allows you, as a real estate investor, to defer the federal and state income tax that would normally be incurred from selling real property, by using the proceeds of the sale to immediately purchase another ‘like-kind’ property.
And if you continue doing this over and over again until you die, chances are that you’ll pay ZERO taxes. Because your property gets stepped up in basis when you die, your heirs can turn around and sell it for the Fair Market Value (FMV), and owe ZERO taxes to Uncle Sam.
Of course, there are some rules that you need to follow, which we’ll cover in this blog.
But the cool thing is that you can use the tax money that you’d have paid the IRS otherwise to fund your next deal.
Simultaneous exchanges are the oldest of these four 1031 exchange methods. Two property owners agree to swap deeds and ownership interest of their properties. While this method eliminates the need to find buyers, it’s usually very difficult for exchangers to find fair-market-value properties with matching debt and equity structures.
Delayed exchanges are the most common form of 1031 exchanges. You have 45 days to identify a like-kind replacement property and must close on the property within 180 days. These two timelines are usually non-negotiable with the Internal Revenue Service; however, the IRS issued Notice 2020-23, which extended these deadlines in certain instances due to the COVID-19 pandemic.
This type of exchange occurs when you acquire a like-kind replacement property prior to fully relinquishing ownership of your current assets. Since you cannot simultaneously have ownership of your relinquished property and the target asset, you must have an Exchange Accommodation Titleholder (EAT) temporarily take possession of the relinquished or target property via a special purpose entity such as a single-member LLC. The EAT then takes possession of either the relinquished property or target property under a Qualified Exchange Accommodation Agreement.
Under this method, you can make improvements on a target asset using the equity generated from the exchange. You can either refurbish or make capital improvements to existing real property, or build new from the ground up. Improvement exchanges can significantly enhance the value of the acquired property. However, the improved or new replacement property must have the same value as the relinquished property. And the 45- and 180-day deadlines still apply.
An experienced real estate accountant can help you determine the best 1031 Exchange method for your business.
There are a few rules you’ll need to follow when enacting the 1031 Exchange, and even more if you reside in a state like California.
If you live in California, you can view our full list of 1031 Exchange Rules for the state here.
If you are undertaking a reverse or forward exchange, you have 45 days from the date of closing of the replacement property to identify which of your properties is going to be sold.
From the original date that the property is sold, at the close of escrow, you have 180 days to complete your 1031 Exchange and close escrow on the new property.
Any type of investment property can be exchanged for any other ‘like-minded’ investment property.
To have 100% of capital gains taxes deferred in a 1031 Exchange, the replacement property needs to have a fair market value that’s equal or greater than that of the relinquished property. Otherwise, any remaining balance after the purchase of the replacement property (also known as “the boot”) is subject to capital gains tax.
Like-kind property in a is a broad description of properties that are defined by the IRS as “the same nature or character, even if they differ in grade or quality.”
In terms of a 1031 Exchange, this means that any type of investment real estate property can be exchanged for any other type of investment real estate property, with the exception of any personal real estate property (such as your primary residence or vacation home), which is not eligible for this type of trade.
Property types that are considered to be “Like-Kind” properties and are eligible for 1031 Exchange are:
When it comes to filing the details of your 1031 Exchange with the IRS, there are a few filing requirements to follow.
A 1031 exchange is reported on the tax return for the year in which the exchange begins, i.e. the year the relinquished property is transferred, using Form 8824, Like-Kind Exchanges. Form 8824 requires a description of the relinquished and replacement properties, purchase date of the relinquished property and the date it was transferred, the date the replacement property was identified and the date it was acquired by the Taxpayer.
Taxable gain is reported on Form 4797 or Schedule D, depending on the character of the property given up. The gain must be allocated between ordinary income depreciation recapture, unrecaptured 1250 gain, Section 1231 gain, and capital gain.
If you have not not acquired the replacement property by the due date of your tax return, typically April 15th, you must file an extension using Form 4868 which extends the due date of his tax return until August 15th. This will enable anyone who begins the exchange late in a tax year, the full 180 days allowed to complete the exchange.
The IRS has 3 years after the return is filed to audit the return. If the return is filed before the due date, the due date is considered the filing date. If the underreported income exceeds 25% of Taxpayer’s gross income, the period for audit, (statute of limitations), is extended to 6 years.
Here are a few 1031 exchange examples from www.smartasset.com that illustrate how it could work in real life.
It’s unlikely you’ll find a replacement selling for exactly the same amount as your original property. With that in mind, let’s say you sell your property with a $300,000 mortgage on it for $500,000.
While searching for a replacement, you find a property you want to buy. But it’s valued at $700,000. In that case, you contribute $200,000 out of pocket and purchase the replacement with a $300,000 loan and $400,000 of cash. Like this, you can still defer taxes since you satisfy the two basic requirements.
One concept in real estate is known as leveraging. Basically, it means using debt, such as a loan, to buy an asset, like property. Investors can increase their leverage using a 1031 exchange, allowing them to invest in a higher-value property. As a result, they can not only improve their cash flow but multiply the rate they build equity at.
So, suppose you sell one of your first investment properties for $500,000. You still owed $100,000 on the mortgage at the moment of sale. But you want to set your sights higher. As a result, you move to purchase a property that costs $1 million.
You use the total profit from the sale at $400,000 and take out a new loan worth $600,000. With this, you meet the 1031 exchange requirements.
It’s actually possible to sell an investment property and satisfy the 1031 exchange rules without using all of your sale proceeds. This is called a partial exchange. However, buying a replacement for a lower cost than the original property’s sale price or taking out less financing will result in taxes.
For instance, we’ll say you sell your original property for $650,000. It had a $200,000 mortgage leftover. You then purchase a property for $500,000 but still take out $200,000 for the loan. The $150,000 in profit unused becomes taxable income.
Essentially, you still defer taxes on the better part of the sale from the first property. But the money that you didn’t put into the replacement still faces capital gains tax or depreciation recapture.
The 1031 Exchange is a powerful tax strategy that you don’t ever want to forgo in your real estate business.
However, the rules and regulations can vary from state to state, and can be tricky to comply with.
The best advice we can give you is to work with an experienced real estate accountant who knows the 1031 Exchange inside and out.
If you don’t have a real estate accountant that you are happy with, or simply don’t have one yet, you can book a quick 15-minute call with one of our team members anytime.
We’ll be happy to help.
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