The 1031 Exchange enables investors to defer – and in some cases, eliminate – the tax liability for highly appreciated real estate assets. It’s not a simple process, but the 1031 exchange is well understood in the legal and investing communities. If you have highly appreciated real estate on which you’d like to avoid or defer the payment of taxes, this guide is for you:
Ever find yourself nodding your head knowledgably because the conversation turned to 1031 exchanges and you didn’t know exactly what they were? No more!
Every time you zone out of a 1031 conversation you are potentially leaving hundreds of thousands of dollars in investment capital on the table. Don’t do that! Here’s your handy guide on 1031 exchanges: everything you need to know about them and how to use them.
First of all, you need a definition that sums these beautiful little tax-code creations up in one sentence:
A 1031 exchange is a transaction in which you swap one investment for another in such a way as to push the tax consequences far into the future (and sometimes eliminate them!).
Already, I suspect your eyes are lighting up. Let’s look at a quick example of just what this might mean:
Say you sell off one of your investment properties and you make a profit of $200,000. Now, under normal circumstances, that profit is going to be subject to some taxes and fees. In fact, it’s quite likely you could end writing a check to Uncle Sam for about a third of those profits, around $60,000.
That means that once you’ve paid your “dues,” such as they are, to our trusty federal government, you don’t have $200,000 to place in another investment. You have around $140,000, or maybe a little less.
Now, can you do some serious investing with $140,000 in capital? Sure! But think how much more you could do if that number was still $200,000. That’s where the 1031 exchange comes in and can really ramp up your investing “muscle” just by helping you keep the entirety of the profits you earned.
1031 Exchanges: Five Important Things to Know Right Off the Bat
1031 exchanges can be, at first, a little intimidating. That is why so many people nod and smile when they come up in conversation but do not actually say anything. Most people just don’t understand them!
We’ll get into the nitty-gritty details later in this guide, but let’s start out with the five important things you must know about 1031 exchanges in order to start leveraging them in your investment strategy:
- 1031 Tax-Deferred Exchanges are great for real estate investing — 1031 exchanges can be used for many types of investments, but they are primarily used in real estate transactions. This is good because:
a) Real estate often results in huge profits, and this is a good way to protect those profits for your own future use
b) Real estate investments are ideally suited to meet the somewhat, well, “unique” guidelines that govern a 1031 exchange transaction. Check out #2 to see why.
- The “Exchange” in “1031 Exchange” Must be Like-for-Like — This means that when you swap one investment for another, those investments must be what the federal government considers “like kind.” You might, for example, swap one car for another.However, in real estate, “like-kind” includes just about any type of property as long as it is also real estate! So you can use your profits from flipping a piece of vacant land on the West Coast to purchase three turnkey rentals in Florida. To an investor, these investments look very different, but to the 1031 exchange, they are like-for-like.
- 1031 Tax Exchanges Happen Fast — 1031 exchanges have a very short time frame. In fact, once you sell the first investment, you have only 45 days to identify and designate the “replacement” investment and send written notification to the IRS and only 180 days (from the same start date) to get your profits reinvested into another asset. That means that if it takes you the full 45 days to identify your replacement investment, you have 135 days left in which to get to closing.
- 1031 Deferred Tax Exchanges are “Cash-Free” — If you have cash “left over” at the end of the exchange, that cash will not be immune from taxes and fees. Looking back to our initial example, if you used $190,000 of your $200,000 profit to buy your next investment and had $10,000 left over, that $10,000 would be taxed even though you did a 1031 exchange.A little 1031 exchange “lingo” for you: That leftover cash is called “the boot.”
- You Can Do 1031 Exchanges Basically Forever — There are very few restrictions on the number of times you can do a 1031 exchange on an initial investment. This means as long as you follow the rules, you could take that $200,000 profit and turn it into $400,000 in profit, then do another 1031 exchange and protect the full $400,000 in order to create $800,000 in profit, and so on indefinitely. However, there are limits on how frequently you can do them, so consult a financial expert about your specific timelines and volumes.
1031 Exchange Exceptions, Exemptions, and Prohibitions
At this point, you’re probably pretty eager to get into the details about how these things work, and we’re almost there! However, before we dive into the fine print of how to do a 1031 exchange right now in today’s regulatory environment, you need to be aware of a few things that the IRS simply will not tolerate in your 1031 exchange.
You might as well know the “no-go’s” up front, right?
Here are assets that cannot be swapped in a 1031 exchange (and a few prohibited behaviors as well):
- You cannot trade:
- Certificates of trust
- You cannot involve your personal residence in a swap. This usually includes a second home or “primary” vacation residence.
*note: there are some ways to turn an investment property or rental into a primary or secondary home and vice versa, but it’s complicated and the IRS is constantly changing and tightening the rules on this.
- You may not swap for property in a foreign country
- You may not swap for houses offered for sale directly by a developer
- Flipping houses using a 1031 is tricky and may be prohibited depending on how quickly you flip and how many houses you flip in a year.
Now that you know what you cannot do in a 1031 exchange, let’s get back to the “fun” stuff: what you can do in a 1031 exchange. That’s right: it’s time for the big reveal of all the “nitty-gritty details.”
The Mechanics of 1031 Exchanges
Ready? Below you will see the step-by-step process of a 1031 exchange. After you read through the steps, we’ll get into the “players” in the 1031 exchange and the details of the different types of exchanges (there are three) that you may choose to employ.
Note: 1031 exchanges are ideal for real estate investors in many, many cases, so we’re going to assume for the purposes of this manual that the investment in our examples and scenarios is a piece (or pieces) of property.
In its simplest form, a 1031 exchange works like this:
- The investor decides to sell a property.
In most cases, once you decide to exit an investment, you can get a rough idea of how much profit you are likely to be dealing with. You should do this.
- Investor starts looking for replacement properties so that they can do a 1031 exchange.
- Investor sells the property and has the profits from the sale “in hand.”
The profits are not actually in the investor’s possession, however. This is important. The money goes into holding by a “qualified intermediary” (QI), which we will discuss in more detail in our “players” section.
- Investor has 45 days from the date of sale to identify the replacement property and notify the IRS.
Ideally, you already have some idea about your replacement property before you even get to closing so that you can move quickly rather than using your entire 45-day window. The IRS allows you to identify more than one replacement property in case something falls through, and we’ll discuss this later.
- QI pays the seller of the new investment property for the property and obtains the deed for the investor.
Don’t forget: this has to happen within 180 days of the initial sale that sent your profits into the hands of the QI in the first place!
- Investor receives the deed for the property (or properties) and starts implementing their new investment strategy.
And that’s a wrap! You’ve just done a 1031 exchange and you have saved yourself (and your investment portfolio) a bundle in the process.
Let’s take a brief look at the “players” in the 1031 exchange:
- The Investor — Usually, that will be you or some business entity that you control.
- The Qualified Intermediary (QI) — The QI may also be referred to as an “exchange facilitator,” so don’t be confused if you hear this term instead of QI. The investor and the QI agree, in writing, that the QI will provide the profits from the sale of the first property a “safe harbor” during the 180-day 1031 exchange window. During that time, the QI pledges to protect the money in their possession from the taxpayer receiving it, pledging it (read: borrowing against it), borrowing the money from the QI, or otherwise benefiting from that money.
- The IRS — No, as much as you wished you could, you could not write the IRS out of the equation entirely. They receive written notice of the replacement property designation as soon as you have identified that property or properties, and there is a slim chance that they may determine your selection is ineligible for a 1031 exchange although, if you do your due diligence and follow the rules, this is unlikely.
- The Seller — The person selling the replacement property. They are important because they will affect the speed of the transaction. You will need to communicate with them so that they are fully prepared to play their part in getting you to closing in that window.
Of course, there are many other players in the exchange that also play a role in nearly every other real estate transaction you do as well. They include:
- Your financial adviser
- Your real estate attorney
- Your accountant
- Closing attorneys
- Banks and/or lenders
Because 1031 exchanges have to happen quickly, it is important to establish good, open lines of communication with all of the parties who will be involved in the transaction so that you can limit the number of “surprises” you encounter during the 180-day window that could slow you down.
The 3 Types of 1031 Exchange
Now that you know the basics of the 1031 exchange, it’s time to get into the little ways that these transactions can differ one from the other. There are actually three distinctly different types of 1031 exchanges:
- Simultaneous or Same-Day Exchanges — These are the simplest form of 1031 exchange. You literally swap out your investments on the same day, and they can involve a literal trade of properties rather than exchange of money for an asset.Needless to say, same-day exchanges are relatively rare because it is relatively rare to encounter another property owner wants your exact investment in exchange for their exact investment (and vice versa).
- Delayed Exchange or “Starker Exchange — ”A Starker exchange permits a degree of delay when it comes to actually obtaining your replacement property. It can happen in one of two ways, and some people actually think of these two ways as entirely separate forms of 1031 exchange. However, since they both stem from the ruling on the same lawsuit (Starker v. United States, 1979) and result in a longer window for the 1031 process, we have placed them both in the same category.
- Forward Exchange, which involves the process we described above wherein you sell one property, identify a replacement, and close within the 180-day window.
- Reverse Exchange, which involves obtaining title to the replacement property in advance, then selling your original property
Starker exchanges are certainly more complicated than simultaneous exchanges, but they are far more common since, as we mentioned, it is pretty unlikely that you will find yourself in a situation that would allow for a same-day exchange very often, if ever.
- Improvement Exchange — Remember that “boot” we talked about earlier? Here is a good way to fit that leftover money into your 1031 exchange and improve your property in the process! An improvement exchange, which may also be referred to as a “construction exchange,” allows you to make repairs to the replacement property using that “leftover” money from the sale of the first property that you did not spend directly on the purchase of the replacement.While this sounds like a perfect solution to your “boot” problem, there are a few bits of fine print that you need to consider:
- Improvement exchanges must occur within the 180-day window.This means that you cannot buy a piece of undeveloped land and use the “boot” to build a duplex on it unless you can complete the duplex within the 180-day window.
- You have to pass the “Napkin Test”The Napkin Test determines whether or not you have a “boot” in your 1031 exchange by confirming that the replacement property has either gone across or up in value from the one that you sold to start the 1031 process. Subtract the first property’s value from the replacement property’s value. If you get either zero or a positive amount, then there is no boot. In a construction exchange, after improvements, when you perform this calculation you need to get either zero or a positive value as well.
The “Million-Dollar” Question: Can I 1031 Exchange My Vacation Home?
Many self-directed investors are often disappointed to learn that it is quite difficult to purchase a vacation home as an investment property using their self-directed IRA without committing a dreaded “prohibited transaction.” They sadly give up on the idea of tax savings via this route. When they learn about 1031 exchanges and the massive tax savings that accompany this strategy, they immediately start thinking about that tropical island retirement home once again. That’s a good thing to be pondering, but make sure you understand what you’re getting into when you add a vacation property to the 1031 “mix.”
While it is possible to 1031 exchange into or out of a vacation home or second residence in some unique circumstances, there is a lot of “fine print” to read on the matter, and the IRS is constantly changing the rules on the subject. In fact, some analysts actually call the entire topic a “study in contradictions!”
In this article, we’ve listed the most current guidance for 1031 exchanges and vacation/second homes. Be sure to check back frequently, as the rules are updated and adjusted regularly depending on the outcomes of IRS studies and even lawsuits.
Here’s How It Works in Theory:
Say that you own a beautiful and valuable vacation home in Tahoe, where the median home value is higher than $400,000 and there are plenty of multimillion-dollar mansions to go around. You decide to sell your vacation property in the area, and you expect to get around $2 million for it. After you pay off the mortgage, you’ll be left with about $1.2 million in profit, which means that you’ll be paying a very high capital gains tax on all your profits over $500,000 (so you’ll pay about 25% on $700,000, or about $175,000 in capital gains taxes to the federal government and additional money to the state).
Note: Given that you own a home in Tahoe, it’s unlikely that you will qualify for a lower capital gains rate that someone in a lower tax bracket might pay. Investigate this option if you think it might apply to you.
You think that $175,000 in taxes is a little steep, and so you decide to use a 1031 exchange when you sell that property. You’re thrilled, because it means you will be able to use the entire $1.2 million to purchase another property. You sell the house, do the 1031 exchange, and soon you own a profitable apartment building in the middle of Florida thanks to your savvy maneuvering and your ability to pay $1.2 million in cash for the new replacement property. You live happily ever after. The. End.
So that’s how it works in theory. In reality, using 1031 exchanges on vacation homes is a little bit more complicated.
Let’s get into the fine print. In our example above, you sold your Tahoe mansion and used the profits from the deal via a 1031 exchange to purchase a multifamily property in Florida. Sounds great, right? After all, you only spent three weeks a year in Tahoe, and two of those weeks you had to play host to your in-laws. An apartment building is a vast improvement…
Those three weeks are crucial, though. Here’s why:
Your 1031 exchange likely will not be challenged by the IRS (this means, you qualify to do it) if you meet these two requirements:
- 24 Months of Consistent Property Ownership
You must have owned the Tahoe estate for at least 24 months immediately prior to the exchange or own the replacement property (the multifamily in Florida) for at least 24 months after the exchange.
- Your Personal Use and For-Profit Use of the Properties Meet the “Magic Number” Requirement. The Magic Number is 14.
You must have rented the Tahoe property at fair market rates for 14 or more days each year during the 24 months prior to the sale, and that you cannot have used that property yourself for 14 days each year or 10 percent of the number of days that you rented out the property.This means that if you only used your Tahoe property for personal use during those three weeks we mentioned earlier and kept dust covers on the furniture and the door locked the other 49 weeks of the year, you cannot 1031 exchange it. Likewise, if you rented it to your cousin for $500 a month (average rents in the area are nearly four times that), you cannot 1031 exchange it because you did not rent at fair market rates. However, if you rented the property out at $2,000 a month for five months each of the previous two years (roughly 150 days each year), then as long as you did not spend more than two weeks in the property using it for personal purposes, you’re in the clear as far as the IRS is concerned.Note: According to IRS code 26 CFR 601.105, you can also meet the requirements for a 1031 exchange by using your replacement property (the Florida multifamily in this case) to meet that 24-month criteria. While this might seem to make things simpler, it does not necessarily do so. There are a lot of tax filings and other requirements that you must meet to prove that your replacement property is primarily an investment, and you should consult your legal and tax advisers to determine what steps you need to take to prove that your replacement property’s activity qualified you for the 1031 exchange.
Okay, I’m still feeling good about this 1031 vacation-home exchange. What’s next?
If you still believe that you qualify for a 1031 exchange on the sale of your vacation property or if you believe that you’ll be able to justify the purchase of a vacation home as a replacement property in a 1031 exchange, let’s take a closer look at some of the things you’ll need to consider moving forward:
- How will you handle depreciation?
A great way to show that you’re using a property for investment purposes is to take the depreciation (loss of value) and associated tax deductions that an investment property qualifies for. Do you have a tax expert working with you who can help with this?
- Where will you list the property for rent?
Sure, you can only list privately, but if you really don’t use the property more than 14 days a year for personal use and enjoyment, then wouldn’t you be casting a wider net for tenants the rest of the time? The IRS thinks so, and while you do not have to list on VRBO.com or other public online sites, it’s a good idea.
- Have you hired a management company?
Working with a local property management company to keep your property in good shape and ready for rental use is a good idea for any investor. It also demonstrates that you are treating the property like a business venture, not personal property.
- Are you paying (and excluding) the right taxes?
Are you taking advantage of the lower tax rates on personal residences or claiming a mortgage interest deduction on your vacation property? If so, then you’re probably disqualifying that 1031 exchange as we speak!In the case Barry E. Moore v. Commissioner, a property owner attempted to 1031 exchange a lake house that he and his family had used on the weekends from April to Labor Day each year for another lake house closer to his personal residence. He claimed that the property was an investment because he planned to make money as a result of appreciation when he sold it, but never rented the property out. The court ruled that the properties did not qualify for a 1031 exchange because they were clearly intended primarily for personal use and enjoyment.
The eligibility of a property for a 1031 exchange is often fluid and based on specific facts and unique circumstances. However, you can hedge your bets, so to speak, by making consulting experts on the topic and doing your own research to make sure that the IRS will uphold your conclusions about your planned exchange!
So What Happens When a 1031 Fails?
Savvy self-directed investors always do their research in advance, so it’s unlikely that you will end up with a failed 1031 exchange whether you are trying to incorporate a vacation property into the mix or not. However, as we mentioned: the rules on this specific angle of vacation homes in 1031s are constantly changing. You could get caught in the “undertow” and end up in a failed 1031 exchange! What then?
Well, a 1031 can fail for two reasons:
- The IRS disqualifies it
- One of the parties backs out
As with many facets of the 1031 exchange, this list is deceptively short and simple. For starters, it makes it appear that you can simply ask your qualified intermediary (QI) to release the funds from the initial sale to you if you decide not to do the exchange. Unfortunately, this is not necessarily an option. Your agreement with your QI specifies that the 1031 exchange period can only be terminated under certain circumstances, and “I changed my mind” is not one of them. However, you can effectively terminate the exchange 46 days into the timeline by opting not to identify a replacement property.
If the IRS says you have not actually identified eligible replacement properties, the process is (shockingly) far simpler: you can try again, or pay your capital gains taxes, depending on where in the timeline of the first 45 days that rejection occurs.
In the event that you plan to purchase a vacation home using a 1031 exchange or sell one using this transaction strategy, consult an expert before doing so! You might end up deciding to sell anyway, but you also might decide to hold the property a little longer in order to insure that it’s wholly eligible for this highly attractive strategy.
Tying It All Together
You are probably starting to rub your hands together with glee as you begin to realize the huge potential that 1031 exchanges represent for your real estate investing power. So do we, every time we think about them!
In the next installment, we’ll dive into some simple examples of 1031 exchanges as well as some more complicated case studies and real-life examples of how real estate investors use these tax-code “goodies” to make massive differences in their available capital.
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About The Author
Bryan Ellis is host of Self Directed Investor Talk, America's #1 podcast and for affluent self-directed investors. He's also an expert in self-directed IRA's, solo 401k's and 1031 exchanges. You can find Bryan's writing in very highly respected publications including Forbes, Entrepreneur and TheStreet. Bryan lives in metro Atlanta, Georgia with Carole Ellis - his wife, business partner and best friend - and his 4 children ranging in age from 2 to 19.