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.

We’re republishing this article to help out our newer readers.

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.”

58 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

        • Andrew K.

          What if you wanted to take the capital gains from a investment property (title held personally) and put it into a syndication as a passive investor?

          Could you contribute the cap gains to the LLC and have that LLC be the member of the syndication multi-member syndication?

      • Scott Armstrong

        What if the relinquished property was in my name only (bought it before i was married), but now buying a larger unit through a 1031 and qualifying for the new mortgage with my wife. Would it be OK to have both our names on title since we file taxes jointly and because we are qualifying for the loan together? Or does it still need to only be my name? Thanks!

  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

  7. Ishmael Carter

    Matt, as always, great contribution. I just sold a fix and flip on 1/25/18 and would still be in the 45-day window to identify a replacement property. If the property was sold for $150k, i would need to identify a property of the same value- $150k?

    Any recommendation of 1031 Intermediaries if could work with?

    Thanks

    • Matt Faircloth

      Hi Ishmael,
      You can’t do it on a fix and flip because it wasn’t “investment intent”, unless you had a lease on the property and can show that it was a rental unit. Also, you can’t start the 1031 process after you sell the property. Sorry for the bad news!
      Matt

  8. Dan Redmond

    Matt,

    There was just a repost of your video in May 2018. Agree with all you stated. As we just passed our 45 days in an exchange and have learned much. The one item that you did not address and we knew nothing about until we got started with our intermeditary, one must also us up the former remaining mortgage amount, ot that amount is also taxable. While we sold a buy and hold property (20 years in) so our remaining loan was smaller than most and we were able to owner finance our new property to more or less the same amount, this is an item that shorter term holders should certainly be aware of. Thank you for what you did.

  9. Carrie McPeek

    I have owned a house for eight years and lived there the first four years. When my husband passed, I turned it into a rental and found a smaller place to live. It generates great rent, but I feel like I could do better by purchasing two or three houses out of the proceeds. I am assuming I can do this through a 1031 exchange based on the video.

    I purchased the house for 175,500, and I believe it will sell as high as 235,000. If I understand correctly, I would be liable for capital gains of the difference in the purchase price and sales price plus depreciation.

    Recently I took out a $100,000 Home Equity loan on the house to help me purchase two single family homes as rentals.

    Is there any way to sell the house, pay off the HE loan and use the remaining amount to purchase a couple rentals and still stay within the 1031 framework? Or does it all need to be applied toward the new purchase(s)?

    Also, would any expenses incurred like closing costs and those occurred over the years reduce the capital gains amount?

    • Matt Faircloth

      Hey Carrie,
      First, if you lived in the house earlier than 2 years ago you can sell it and receive up to $250,000 tax free as it’s still viewed as a former primary residence.
      If not, you can do a 1031 exchange. You would need to pay of the HELOC not because of the 1031 but because you are selling the bank’s collateral, so they will want a payoff. All the proceeds aside from that can get rolled in to the 1031 exchange. You just need to take all the profit you get from the sale and roll it to the new purchase.

      Matt

    • Proncias MacAnEan on

      Worth doing a little research on this. For the primary residence exemption you have to have lived there for 2 of the last 5-years. From your description it sounds like you are getting close to the end of that period. This would be a better option than the 1031 as you would start the next property with a higher basis.

      There may be one complication here though. The IRS used not look at how the property was used so long as the owner occupied it for those 2-years. It is my understanding, and I’m no expert so I could be wrong, but the IRS changed this so, as in your case, if the property was your residence for 1/2 the time and a rental the rest, then you’d only get 1/2 the gain tax free, and the rest would be taxed at long term capital gains rates.

  10. James Bennett

    Matt. I am preparing for my first 1031 exchange. Yesterday I met with a 1031 agent. There was one detail they listed that was a requirement that I never heard from anyone before. Your video didn’t mention either. Maybe they didn’t explain the requirement clearly or maybe their information is incorrect. I did question their explanation and they repeated the same answer. Using your example: A duplex purchased for 100K and sold for 200K. They explained that even though I have a mortgage that will need to be paid off, lets say 75K, that I still need to use 200K, the total selling price, s the money for the next deal. Rather than the equity from the sale the entire sales price. To be clear the money to go into the exchange would need to be 200K, not the 125K (200K sales price – 75K for mortgage). That would mean I have to add another 75K out of pocket to make the exchange work.
    Is that correct?

    • Matt Faircloth

      Hey James,
      As I understand the rules, the new purchase needs to be at or above the sales price of the sold property. How you come up with the cash to buy the new deal is outside of the IRS concerns. You can borrow it or use equity from the sale. Additionally, you cannot take any profit from the sale of the first. So all sales proceeds need to be held in escrow and used in the new deal.

      These two things are mutually exclusive. The IRS doesn’t care how much your prior mortgage was and they dont care how much you borrow on the next deal. I hope that helps!
      Matt

  11. Patrick Fales

    That’s a good question from James that I am curious to know the answer too. Along the same lines are you able to pocket any of your equity? I see taxes being due on the $115K in Matt’s example if you don’t buy another investment but it makes no sense why the IRS would require the $200K to go into the next investment.

  12. Moty Wall

    Hi Matt,
    Thanks for your great presentation.
    I still have a question which I want to clarify using an example with the following assumptions:
    1. Investment property was purchased for $100,000, paying 30,000 down and 70,000 from a lender.
    2. Property for sale 2 years later for $200,000.
    3. Assuming $20,000 for closing and 1031 exchange costs, the capital gains are $80,000.
    The question is – what is the minimum amount which one must use for the new property:
    A. $80,000 and up? (profit or the capital gains)
    B. $30,000 + $80,000= $110,000 (Down payment + profit)?
    C. $180,000 (Selling price less selling costs)?
    Thanks

  13. Dan Redmond

    Moty, We are in the middle of our first 1031 so are by no means experts, but our current understanding is that there is no minimum for using the proceeds. That said, all of the upside from the original deal including the prior mortgage is taxable if not used. In your case, if I read your situation correctly, to avoid furture capital gains you would need to invest the 100K profit and the 70K loan in a new property, your original down does not come into play. Hope I am correct and hope this helps. If wrong I will stand corrected. Good luck. I would speak with your tax advisor and a 1031 intermidery to confirm.

  14. Suzanne F Taylor

    I am planning to sell a rental condo I purchased for investment purposes when single. I want to use the proceeds in a 1030X to buy into a rental my new husband has owned with a business partner. The partner wants to sell his half of the rental to me. Can I buy the partner’s half or does it void the “taking title” rule you mention in your terrific video. Thanks.

  15. Jim Maxwell

    I am starting the process of selling a 4-plex held in an LLC and want to do a 1031 exchange. We originally purchased the property in our personal names because we used conventional financing and the bank would not lend to an LLC. After the deal closed we deeded the property to our LLC.

    Your point about keeping the entity in the same name got me thinking. If we sell and get financing again I am curious how on a residential property (4-plex) we would get the bank to loan on the LLC? Should I get a commercial loan and then refinance to a residential loan? (I like the 30 year amortization, especially in a rising interest rate environment) That seems expensive. Looking for ideas.

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