The 1031 exchange, also known as a like-kind exchange or a Starker, is a key tool used by real estate investors who hold property long-term (as opposed to flippers). At its core, the 1031 exchange allows investors to defer capital gains tax when “selling” a property.
Many investors become serial exchangers, using this tool to help them build wealth as they replace older properties with more valuable ones, and defer tax liability in the process. In addition to the tax deferral benefit, there are several other advantages, as well as a few potential drawbacks, to the 1031.
In this article, I cover what I believe are the most important advantages and disadvantages and provide some food for thought about times you might want to sell as opposed to exchange. The wisdom in deciding to use a 1031 exchange will depend on your specific financial situation and goals, so always consult a tax professional before deciding if a 1031 exchange is right for you.
What Is a 1031 Exchange?
In general, a 1031 exchange is an exchange of real property used for business (or held as an investment solely for another business) for an investment property that is the same type, or “like-kind.” Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality.
What Are the Rules of a 1031 Exchange?
The range of property types included under the Internal Revenue Code Section 1031 was reduced with the passing of the Tax Cuts and Jobs Act. Only exchanges of real property currently qualify. However, the rules remain broad when it comes to the type of real properties allowed.
For example, real properties can be improved or unimproved. In some instances, you can even use a 1031 to exchange vacation homes, but there are many stipulations that must be met in order to do so. An exchange of real property held primarily for sale (think fix and flip) has never qualified as a like-kind exchange. The key condition here is that the property being exchanged (sold) must have been held for “investment” purposes.
There is no definition of what “investment purposes” is, but most industry professionals interpret this to mean that the property must have been held or owned for at least a year.
Pros of the 1031 Exchange
The main benefit of the 1031 exchange is the ability to defer or limit your tax liability when you “sell” a property. When you exchange instead of sell, you can avoid paying capital gains tax at the time of the transaction. By avoiding the tax hit, investors can grow their wealth faster because the all of the sales proceeds can go towards purchasing a larger or more valuable property.
No Tax Liability Upon Death
Another benefit of the 1031 exchange is that the deferred taxes owed to the IRS are erased upon death. A common investment strategy is to use multiple 1031 exchanges to purchase many more valuable properties throughout an investor’s lifetime. This allows investors to grow their wealth tax-free. Upon their passing, their heirs receive the property at what’s called a stepped-up basis equal to the fair market value of the property at the time of death and no capital gains tax to pay.
There is no limit to the number or frequency of 1031 exchanges allowed.
Cons of the 1031 Exchange
While there are benefits to using a 1031 exchange, they also come with a few potential drawbacks. To use a 1031 exchange successfully, investors must be aware of, and adhere to, some extremely strict rules.
Qualified Intermediary Required
When doing a delayed exchange (and the vast majority of exchanges are delayed), a qualified intermediary must be used to handle all the paperwork and hold the sale proceeds during the exchange period. Investors cannot take possession of the proceeds and still qualify for the tax deferral.
There are also strict timeframes that must be met:
- 45 days to identify up to three properties to purchase
- 180 days to acquire one of the three properties
- Note that the two time periods run concurrently. If you take 30 days to identify your replacement property, you’ll only have 150 days to close.
Severe Repercussions If a 1031 Exchange Fails
If you’ve completed a number of successful exchanges and the most recent one fails, the proceeds are returned to you. Capital gains tax on that exchange, as well as part or all of the deferred taxes from previous exchanges, will be owed.
No Access to the Cash
When you complete an exchange, you do not take ownership of or have access to any of the cash from the proceeds.
Failing to Consider Loans
If your liability goes down as a result of the exchange, the IRS will consider that debt reduction as income with the associated tax liability.
Questions to Ask When Deciding Whether to Sell or Exchange
When faced with the decision to exchange or sell, it is important to look at the big picture. Sure, a tax deferral always sounds great, but it shouldn’t be the only factor under consideration. Here are a few other things to carefully think about before making your final decision.
What Is Your Potential Tax Liability?
At face value, it always sounds better to defer/avoid paying taxes, but you should know what your potential tax liability will be if you were to sell the property. You might be surprised—it could be tolerable or even acceptable.
How Badly Do You Need the Cash?
Sometimes life happens, and you just need the cash.
Are There Any Sticky Legal Entity Issues?
If the property to be sold was purchased through a legal entity (an LLC, for example), that same legal entity must purchase the replacement property. If all members of the entity cannot agree on what is to be done, the most expedient course might be to sell and distribute the funds.
Note that exceptions apply to legal entities structured as Tenants-in-Common (TIC) or as a Delaware Statutory Trust (DST), both of which allow for multiple partners/members to conduct a 1031 exchange individually without being tied to the group.
Do You Have a Loss That Can Be Offset?
If you have a net operating loss or passive activity loss that is expiring soon, it might make more sense to sell rather than exchange. You may be able to (at least partially) offset the gain by the tax losses.
What Is Your Capacity?
Do your current life priorities allow you enough bandwidth to find replacement properties and move swiftly to close within the required 180 days? Can you identify good properties for the exchange within the allotted 45 days?
If you can’t find a replacement property that stands alone as a good investment, it may be better to sell and take the tax hit. Why saddle yourself with a dog?
There are many pros and a few cons to 1031 exchanges. Successful 1031s can be a powerful tool for building wealth through real estate. But there are strict requirements and a few pitfalls to be aware of—especially for those new to 1031 exchanges. Be sure to work with qualified professionals to ensure all the rules are being followed and the exchange fits with your current tax situation.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.