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What is a 1031 Exchange?

A 1031 exchange is a strategic tool for real estate investors to defer capital gains taxes by reinvesting the proceeds from the sale of one property into another like-kind property.

Whenever a business or investment property is sold and the seller makes a financial gain, they generally have to pay tax on the gain at the time of sale.  However, IRC Section 1031 provides an exception and allows the seller to postpone paying tax on the gain if they reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.

1031 Exchange Key Elements

Why use it?

Increased Buying Power

By deferring capital gains taxes, you have more capital available for reinvestment. This increased buying power allows you to acquire higher-value properties, leading to greater cash flow and appreciation potential.

Portfolio Diversification

A 1031 exchange enables you to diversify your real estate holdings. You can exchange properties in different locations or switch between property types (e.g., residential to commercial), reducing the risk associated with localized economic downturns.

Wealth Building

Continually deferring taxes through 1031 exchanges allows you to compound your investment returns. If you hold the final property until death, the step-up in basis rule can eliminate the deferred tax liability, allowing heirs to inherit the property at its current market value, potentially tax-free.

Estate Planning Benefits

1031 exchanges can be a strategic tool for estate planning. By deferring taxes and reinvesting in higher-value properties, you can grow the value of your estate. The step-up in basis rule can provide significant tax advantages to heirs, reducing their potential tax burden. A 1031 exchange offers the opportunity to upgrade to properties that better meet your investment goals. For example, you can exchange an older property for a newer one with lower operating costs, improving cash flow and reducing management


Inflation Hedge

Real estate is often a good hedge against inflation, as property values and rents typically increase over time. Using a 1031 exchange to continually upgrade and expand your holdings can protect your portfolio from inflationary pressures.

  1. Like-Kind Property

Both the sold and purchased properties must be for investment or business use, not personal use.

  1. Timing Rules
  • 45 Days: Identify potential replacement properties within 45 days of selling your original property.
  • 180 Days: Complete the purchase of the replacement property within 180 days of the sale.

  1. Qualified Intermediary

A neutral third party must handle the sale proceeds and purchase the replacement property to ensure compliance with IRS rules.

  1. Title Holding

The same entity that owns the original property must also own the replacement property.

  1. Reinvestment of Proceeds

To fully defer taxes, the replacement property must be of equal or greater value, and all sale proceeds must be reinvested. Any leftover cash, or "boot," is taxable.

  1. Investment or Business Use

Both properties must be used for investment or business purposes.

  1. Documentation

Maintain detailed records and file IRS Form 8824 with your tax return for the year the exchange occurred.

  1. Missing DeadlinesTiming is critical in a 1031 exchange. If you don't identify replacement properties within 45 days or complete the exchange within 180 days, the exchange will be disqualified, and you'll owe capital gains taxes.

  2. Non-Qualified PropertiesOnly properties held for investment or business purposes qualify for a 1031 exchange. Personal residences, stocks, and bonds do not qualify.

  3. Improper Use of FundsDuring the exchange, the proceeds from the sale must be handled by a qualified intermediary. If you take control of the funds, the exchange will be disqualified.

  4. Not Reinvesting All ProceedsTo fully defer taxes, you must reinvest all proceeds from the sale into the new property. Any leftover cash, known as "boot," is taxable.

  5. Selecting an Unqualified IntermediaryA qualified intermediary is essential for a successful exchange. Choosing an unqualified intermediary can lead to disqualification.

1031 Exchange Timeline

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