4 Rules of 1031 Exchanges Every Investor Should Know

by | BiggerPockets.com

Let’s say you’ve got yourself a rental property and you’ve worked hard to get rents up and keep expenses low. The property is profitable, and you are looking to trade up by selling it and buying a more expensive property. The problem is that if you sell, you will have to pay capital gains tax on the sale as you would with a fix and flip or wholesale deal. That tax could be a heavy hit if you have sold the property for a gain, and it will stunt your growth as an investor. What can you do?

That’s where a 1031 exchange comes in. A 1031 is a vehicle through which you can sell rental real estate and roll all the gains into a new purchase. Sound good? In today’s video, I go into detail on the rules of 1031s.

Related: 2 Make-or-Break Rules to Follow for a Successful 1031 Exchange

4 Rules of a 1031 Exchange

Here are the highlights:

  1. It must be a qualified transaction, meaning the property you sell must be held for investment intent. You have to hold it for passive income, not capital gain. In other words, fix and flips don’t qualify.
  2. The property you sell and the one you buy must be held by the same owner. This means you can’t sell a property held in your personal name and buy one through an LLC. Watch the video for an idea how to get around this one!
  3. Once you sell, you have 45 days to identify potential new purchases and 180 days to actually close on the transaction.
  4. There are no extensions, meaning if you don’t close that new purchase 180 days after you sell, you have to pay tax on the gain. No exceptions.

In the video, I go over some tricks of the trade I learned with 1031 exchanges and tell some stories of my experiences with them.

Be sure to watch, and please leave a comment so we can get some chatter going!

About Author

Matt Faircloth

In 2005, Matt founded The DeRosa Group along with his wife, Elizabeth. At the time, the two person company owned and managed two assets – a single family home and a duplex. Over the last nine years, they have grown the company to a 12 person team owning and managing over five million dollars in residential and commercial assets throughout the central NJ and Philadelphia area. One of DeRosa’s mantras is “to make money while making a difference.”

32 Comments

    • Matt Faircloth

      Hey Adam,
      You can hold for longer or do the BRRR but either way you will have to pay some capital gain tax on the sale unless you do a 1031 exchange. The BRRR is great if you want to pull out some of your equity tax-free as a loan, but you will leave some equity on the table unless you completely sell the property.
      Matt

      • Adam Schroeter

        I agree. Or else there would be no need for a 1031. Maybe I need more info on bullet 1. I must sell but I must hold? Is there a required time frame? Or do I just need to have it make income dying my holding period? That’s is more of what I was asking. Thanks for the reply.

        Adam

        • Matt Faircloth

          Hey Adam,
          You need to show that the purchase was for investment intent. This is all incase you get audited and many many 1031 transactions do get audited. Ideas on showing investment intent would include putting the property out for lease (even if you don’t rent it ever), getting a Certificate of occupancy for a rental if that’s valid in your area, and of course actually leasing it to someone. There is actually no time factor on how long you need to hold the property from purchase to sale.
          Matt

  1. ChokSheak Lau

    Hi Matt, great video! Thanks for doing this. I think the mechanics of doing the 1031 can be read up and learnt. How about the question of “Should I do a 1031 exchange exit strategy, or is there a better exit?” I have heard two different versions for exit strategies, one is to never sell and then it will become tax free when we pass on, second is to do a cost segregation and get all the tax deductions in the same year you sell. The first I think is viable, the second one seems undoable. What do you think is the best strategy for exiting with minimum taxes?

    • Matt Faircloth

      Hey Choksheak,

      I have heard of the cost segregation method and also using a seller financed sale to spread or reduce the effect of capital gains tax. That being said, the best way to avoid capital gains tax is to either never sell or do a 1031 exchange when you do. Equity can be recaptured over the years through a refinance, and as you said it becomes tax free when your heirs inherit it.

      Matt

    • Yes, it can.

      Also, the above article is incorrect. The “tax owner” has to remain the same from sale to purchase.

      I can sell in my individual name and I can purchase in an LLC, as long as I am the only member of the LLC and the LLC is considered a “disregarded entity”, which most single member LLCs are.

        • A multi-member LLC is taxed as a partnership – so if the relinquished property is owned my a multi-member LLC, then that same multi-member LLC must be the underlying tax-owner of replacement property.
          You could create a new LLC, but the original multi-member LLC would have to be the sole member of the new LLC and the new LLC needs to be a disregarded entity.

      • Matt Faircloth

        Hey All,

        Again, Ryan is correct. You must be a CPA, Ryan! You seem to know a lot about this stuff, lol.

        The rules say that the new property must be held in title by the same owner as who owned the sold property. That would apply to a multi-member LLC or holding in your own personal name. I didn’t think about the single member LLC option but it seems that it would hold up. We have one Single Member LLC, it doesn’t even need it’s own tax return. The income and expenses just pass through to the entity behind them. I could see how the IRS would view them as the same entity.

        Matt

  2. David Krulac

    Matt,

    Thanks for explaining a complicated transaction. I think I did my first 1031 about 30 years ago, even less people knew what it was back then. I had to explain the transaction to the real estate broker, who had multiple offices and lots of agents. His first question to me was, “Is this legal?”

    Your identify first tip is a great one. I did that and ended up settling both the relinquished property and the acquired property the same day at the same settlement office.

    Land can be either the relinquished property or the acquired property in a 1031.

    Personal real estate including your personal residence or a second or vacation home is not qualified to be in a 1031 exchange.

    We talked about 1031 exchange in Bigger Pockets Podcast #82.

    • Matt Faircloth

      Hey David,
      Good to hear from you. I love that someone asked you if 1031’s were legal many years ago. At times it seems too good to be true actually.
      Thanks for clarifying my question on land being involved in a 1031. Quick question – can land be on both sides of a 1031 transaction, meaning selling land to buy a larger piece of land?
      We need to connect and talk about Central PA investments soon. We are making some investments in that part of the world!
      Speak soon,
      Matt

  3. Can you only chose three properties as potential purchase.?
    You said a back up as a safety net but that will have to be one of the three right?
    Also I have a single family home under contract and plan to use a 1031, I can buy a mobile home park or apartment right?
    One more thing, I have an equity line on the home I am selling so the equity line will be paid off at closing. In turn when the proceeds go to the third party it will be less than the sales price. So when I buy a new investment property must i spend the original sales price of the sold property, or the collected amount from closing? Thanks

    ·

    • Matt Faircloth

      Hey Jim,
      As I understand it, you can only choose 3 potential purchases if you plan to buy just one property to complete the 1031. However, if you plan to buy a portfolio of properties as your replacement the rules change, and it gets more complicated LOL.

      Yes, using a safety net like a Tenants In Common purchase would count as one of your 3 options.

      I think you may be confusing cash out of closing and capital gain. Lets say you have a property you bought for 50K. You refinance it with a loan of 95K and then sell it for 100K a few months later. Forgetting closing costs for simplicity, the cash gain on sale is only 5k but your taxable capital gain is 50k. Your new purchase must be for 100K or more and you can’t touch any of the 5K profit from closing, it needs to get held with a Qualified Intermediary in between closings. You will probably have to bring some cash to the closing as well (perhaps some of the cash you pulled out during that refinance) to make the deal happen. You can put a mortgage on the new purchase also.

      I hope that helps!

      Matt

    • Matt Faircloth

      Hey Jim,

      As I understand it, you can only choose 3 possible purchases if you plan to buy just one property to complete the process. However, if you plan to buy a portfolio of properties as your replacement the rules change, and it gets more complicated LOL.

      Yes, using a safety net like a Tenants In Common purchase would count as one of your 3 options.

      I think you may be confusing cash out of closing and capital gain. Lets say you have a property you bought for 50K. You refinance it with a loan of 95K and then sell it for 100K a few months later. Forgetting closing costs for simplicity, the cash gain on sale is only 5k but your taxable capital gain is 50k. Your new purchase must be for 100K or more and you can’t touch any of the 5K profit from closing, it needs to get held with a Qualified Intermediary in between closings. You will probably have to bring some cash to the closing as well (perhaps some of the cash you pulled out during that refinance) to make the deal happen. You can put a mortgage on the new purchase also.

      I hope that helps!

      Matt

    • Matt Faircloth

      Hey Jim,
      As I understand it, you can only choose 3 potential purchases if you plan to buy just one property to complete the 1031. However, if you plan to buy a portfolio of properties as your replacement the rules change, and it gets more complicated LOL.

      Yes, using a safety net like a Tenants In Common purchase would count as one of your 3 options.

      I think you may be confusing cash out of closing and capital gain. Lets say you have a property you bought for 50K. You refinance it with a loan of 95K and then sell it for 100K a few months later. Forgetting closing costs for simplicity, the cash gain on sale is only 5k but your taxable capital gain is 50k. Your new purchase must be for 100K or more and you can’t touch any of the 5K profit from closing, it needs to get held with a Qualified Intermediary in between closings. You will probably have to bring some cash to the closing as well (perhaps some of the cash you pulled out during that refinance) to make the deal happen. You can put a mortgage on the new purchase also.

      Take care,

      Matt

  4. Martyn Lockwood

    Thanks for sharing Matt….very informative.

    I’m guessing that using a 1031 would not be worth worrying about if a property being sold has only gone up by a few thousand dollars from time of purchase?

    Also…is there any limit on how many times one can a 1031?

    Thanks
    Martyn

    • Matt Faircloth

      Hey Martyn,
      There are some fees that need to get paid to the qualified intermediary, and of course you will have closing costs on purchase and sale. If your property has not gone up enough to cover these costs and also put some equity into the new deal, you should probably wait till there is a large enough gap for the sale to make sense.
      There is not limit on the number of 1031’s you can do.
      Matt

  5. Cindy Larsen

    Matt,
    Great video. I agree that 45 days is a eyeblink in investing in real estate. I’m a newbie, and trying to learn as much as I can, and determine exist strategies before I buy. I am currently doing BRRRR sequentially, and in parallel: I’ve already bought (house + MIL cottage) #2, and am about to sell (house + MIL cottage)#1. Because I am living in each property for at least 2 of the 5 years bfore I sell it, I pay no capital gains tax at all on up to $250k of capital gain.

    Eventually, so as not to have to keep moving, I plan to do a 1031, and I’ve been stumped on how to find a great deal in the tight time frame of the 1031 exchange. I had an idea the other day: what if you did a lease with option to buy on one or more target properties? Then, when you sell your property, you can exchange it for one of the properties you have an option on. That woul let me identify a great deal, and get it under contract, then the time 1031 time frame is not a problem. Would that work?

    What about an installmant sale? Is there any way to roll the profits from selling a property into another property that you are already buying as an installment sale? for example, if you bought 20% of a property from another investor, and leased their 80%, could you then later buy the remaining 80% as the target of a 1031 exchange of your other, original property?

  6. Matt Faircloth

    Hey Cindy,
    Glad you enjoyed it! For now you are doing well with the rules around selling your primary residence if you’ve lived there for 2 of the last 5 years as you said. I did that once myself.
    I love your idea on the lease with an option to buy, I hope other readers catch that idea in the comment section here. There is no reason I can think of that you can’t do that. You could do that on a multi family also with a master lease in place that controls the entire building and allows you to sublet the apartments to your own tenants.
    The installment option may be hard as you are not allowed to receive cash on the sale of your property, the payments would need to go to the intermediary, I would think. Seems more complicated than it’s worth.
    Take care,
    Matt

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