The 8 Basic Rules Investors Should Know About 1031 Exchanges

by | BiggerPockets.com

This is the mental math I did when I first heard about the notion of a 1031 exchange: (Has to do with taxes + seems like older male investors use it) x (taxes are boring/complicated) = (Makes me feel stupid/I’ll learn about it another day)

Well, people, that day has come and past! I am now quite familiar with 1031 exchanges because I have two different clients who are in the middle of them. With that said, I’ll do my best to break it down for you and take some of the mystique out of 1031 exchanges.

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

Who is a 1031 Exchange Relevant For?

A 1031 exchange is mostly relevant for people with a rental property. (I’ve heard about work arounds for fix and flips and other types of properties, but that’s beyond the scope of this article.) So, back to the basics: 1031 exchange is relevant for people who want to use the proceeds from the sale of one rental property to purchase another rental property.

Why Would I Use a 1031 Exchange?

The purpose of a 1031 exchange is to defer paying 15 percent taxes on capital gains. So, if you sell a property and you’ve made some money on it, you pay 15 percent on your gains. If you defer your money by using a 1031 exchange, you don’t have to pay those taxes as long as you roll that money into another investment (rental) property. (And, yes, this is the government encouraging you to buy real estate.)*

Note on this, the taxes you could avoid paying could be as high as 30 percent when you consider depreciation costs, etc. But on the surface, it’s the 15 percent capital gains tax you are avoiding here.

Related: How a 1031 Exchange Can Make You Millions

How does a 1031 Exchange Work?

There’s a few important rules here:

  1. The rule works for like kind properties — so passive investment vehicles. You can sell a rental property for another rental property, or a one bedroom apartment for land or a duplex. It’s not necessarily about the property — it’s about the passive income you will get on the property. Simply stated, it’s real property for real property.
  2. From the day you sell your initial rental property, you have 45 days to find a property you wish to purchase.
  3. From the day you sell your initial rental property, you have 180 days to close on a new property.
  4. You must purchase property of equal or greater value than the adjusted value (not the price value — but the adjusted cost basis when taking into account depreciation less commissions and closing costs) of the property you sold, or you will be taxed on the difference.
  5. If you do not close on a property within 180 days of selling your initial property, you pay the capital gains tax on your initial property.
  6. During the interim of selling your first place and closing on your second, you cannot touch/look at/be near the profits from the first place you sold. That money stays with a 1031 exchange facilitator (qualified intermediary) and not, not, not with you.
  7. The old property and the new property must be sold and bought by the same entity. Meaning, if you sell a property as John Smith, you have to buy the new one as John Smith — and not as Smith, LLC.
  8. This point has been debated by the experts, but a good rule of thumb for the majority of you is this: You must own your property for one year and one day to make this 1031 exchange. Otherwise, will be penalized.

These are the basics. If you have more questions about a 1031 exchange, reach out to a 1031 facilitator, a trusted tax professional, or someone you know and respect in real estate. A lot of people are intimidated by a 1031 exchange, but it’s pretty easy. And if you are starting to dabble in real estate investing, it’s better to learn this stuff sooner rather than later. If you want a recommendation for a good 1031 facilitator (aka, a qualified intermediary) or would like to discuss more, private message me and I’m happy to discuss!

**And a special thanks to fellow, BPer, Lisa Reyna and her inner 1031 nerd — for good 1031 and tax related chats.  

Do you have questions about 1031 exchanges?

Ask them below! 

About Author

Erin Spradlin

Erin Spradlin co-owns James Carlson Real Estate. She loves working with first-time homebuyers for their enthusiasm and excitement, and loves working with investors because she’s a fellow spreadsheet nerd. She and her husband own three properties in metro Denver and are currently in the process of acquiring a duplex in Colorado Springs. You can find Erin’s blogs here: https://www.biggerpockets.com/renewsblog/author/erinspradlin/ and her airbnb video series here: https://www.youtube.com/playlist?list=PLgSUZKLPRI9tK3Vd-qpH3Sk2Rh-_pIrNN.

21 Comments

  1. Ryan Fong

    Great article thanks Erin.
    Regarding rule #7 I’d like to add that my understanding is you can buy property owned by a single member LLC disregarded for tax purposes. So in your example indeed Smith LLC can purchase the replacement property relinquished by John Smith as long as Smith LLC is a single member LLC owned and managed by John Smith himself.

    • Joanne Szewc

      I agree as I am a solo in diregarded llc entities, and as long tax returns, from my understanding, report properties directly onto the solo person ams not have llc tax return, then all good to have different llc selling and buying.

  2. John Barnette

    And the 45 day identification document is not filed with your tax return. Read between the lines. I have been lucky enough to meet the 45 days in my exchanges. Has anyone with positive or negative experience not making the true identification within 45 days…but still close on replacement by 180 days?

    • Erin Spradlin

      Honestly, in Denver/Colorado Springs this potion of the 1031 is a bit of a non-issue. You have to identify and execute so quickly, that you would almost always hit your 45 and 180 day marks (and especially the 180 mark.)

  3. Bryce Sablotny

    Thank you for the article. I am heavy searching for my first real estate purchase. I want to be a landlord but I have many questions. I want to create a process to set in place to maximize profits and minimize mistakes. The 1031 exchange will be on my mind if I am looking to upgrade properties in the future.

    • Maria Rangel

      Hi Bryce, a great opportunity to be a landlord is in Cleveland Ohio. We offer turnkey properties from Mid $40k, 13% cash on cash. Properties come with tenant placement and property management. You just collect the checks!! Check out avanticlevelandinvestments.com for information. Would love to help you get started! Thanks -Maria 909-321-4479

  4. Dennis Patterson

    I enjoyed this article- it was very helpful. We are currently building in Idaho and plan on living there full time by next year. We retired here in Oregon a few years ago and as we completed that endeavor we invested a large portion of our portfolio building a subdivision and keeping a portion of it we turned into a 55 plus rental complex. For now we will keep this complex in Oregon but at point would love to transfer this investment portfolio to Boise Idaho. Anyone out there want to advise us how to approach this? We would be so thankful
    – Dennis

  5. Michael Seeker

    It’s worth adding that LTCG tax can be 0%, 15% or 20% under current tax code. The benefit of deferring taxes varies quite a bit depending on the amount being gained on sale and the bracket the seller is in. If you’re in the 0% bracket then a 1031 exchange has no benefit (it’s actually a negative). If you’re in the 20% bracket and have a small capital gain, it may not be worth the hassle to go through an exchange.

  6. Bill Brandt

    I think you should clarify point #4.

    Reading it out loud makes it sound like I need to only buy a property higher than my depreciated value minus costs of selling which can’t be true.

    If I have depreciated a million dollar building to zero over 27 years and my adjusted value/cost is zero I can’t exchange it in to a $1,000 shack (higher than my adjusted cost) and keep the rest tax free. Otherwise I would then donate that $1,000 shack to a church and avoid all taxes.

  7. Carol Kotchek

    Could you clarify this statement for me?
    “Note on this, the taxes you could avoid paying could be as high as 30 percent when you consider depreciation costs, etc.”

    I’m going to execute a 1031 exchange this fall and probably not spend all of the funds. So if I don’t spend $30,000 of the proceeds am I only paying the cap gains tax ? What happens to the depreciation I’ve been taking all these years on the property I’m selling?

    Also, can you clarify what 45 days to identify property means exactly? What actions qualify as Identifying property? Going to look at it? Making an offer?
    Thanks for your help and the article.

    • Erin Spradlin

      Hey Carol- here is the response I got from my 1031 specialist on this. If you need the name of a good 1031 specialist, private message me and I’ll get you one. Thanks.

      “The IRS rules require that the identification be in writing, signed by the taxpayer, unambiguously describing the property (an address or legal description), and sent to a qualified recipient (usually the 1031 intermediary) prior to midnight on the 45th day. There is no requirement to actually be under contract. Once an identification list is submitted, it can be revised, revoked and changed as much as you want until midnight on the 45th day -than that list is locked in stone.”

  8. Keilah toy

    Thanks for the informative 1031 article! Any advice on our dilemma below?
    We have property that we’d like to exchange but the title is in a bit of a mess. It’s in three names, two of which are trusts. One trust owner passed away over a decade ago, and the second trust owner passed away a couple of years ago. Both trusts names our sons as beneficiaries. Throughout this time, we as trustees, have been renting out the properties. We wanted to exchange it for MULTIPLE properties out-of-state.
    1. If we chose to update the title (to living parties, or change it into an LLC), will we have to wait two years before exchanging the property?
    2. Would it be a foolish idea to exchange it with its existing title, convoluted as it may be? And wouldn’t this be a risk because we’re exposing multiple properties to liability?
    Any advice would be appreciated! Thanks!!!

    • Ryan Fong

      This sounds like a great question for a 1031 exchange intermediary. You’d be able to vet them and see if you like them for doing your exchange anyway. PM me if you like my contact at IPX1031 or another firm in San Francisco (BTW it doesn’t matter where the intermediary is located they can help with a transaction anywhere).

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