If you’re a real estate investor, chances are you’ve heard of the 1031 exchange. However, if you’ve never done one before, understanding how they work can be overwhelming. There are a ton of rules that need to be followed, and most of them are incredibly stringent.
That’s where we can help. There are around 10 rules that are the most important, common to all exchanges and are the most common offenders when it comes to confusing investors. We’ll dive into exactly what these rules are and how to satisfy them to successfully complete an exchange.
What Is a 1031 Exchange?
1031 exchanges get their names from Section 1031 of the Internal Revenue Code (IRC), the book of rules and regulations outlined by the IRS that all taxpayers have to follow. Simply put, Section 1031 of the IRC states that an investor or business can sell a piece of property that’s being held for investment purposes and roll the capital gains into another property tax-free.
Unlike many other investments, this means you can buy and sell real estate without having to pay your capital gains tax on each transaction. As you can probably imagine, being able to take full advantage of the appreciation of a property without having to pay capital gains taxes is an incredibly powerful tool. In some cases, 1031 exchanges allow investors to walk away from a transaction with an additional 30%-50% of their gains simply by deferring taxes.
Having the ability to defer these taxes can help a real estate investor grow their wealth at an incredibly fast rate, as they aren’t paying nearly as much of their net income out in taxes when compared to other business owners or investors.
Now, without further ado, we’ll jump right into the 10 most important 1031 exchange requirements that every single real estate investor should know.
1. You Can’t Touch the Money During the Exchange
The first and probably most obvious rule of the 1031 exchange is that you cannot touch the money while the exchange is taking place. This means that the proceeds of your sale will be in the hands of a third party for up to 180 days while you wait to close on either the purchase of your new property in a forward exchange or the close of your relinquished property in a reverse exchange.
The person holding your money must be someone you do not have an existing relationship with—no family members, business partners, or real estate services groups you’ve worked with recently (like a broker or lender). If someone who fits this description receives control of your money at any point throughout the transaction, this is considered “constructive receipt” of the funds and automatically nullifies the transaction, forcing you to pay those dreaded capital gains taxes.
While you could hand your money to a stranger off the street, most people find a qualified intermediary that specializes in facilitating 1031 exchanges. This way, you’ll be working with a trusted company with appropriate insurance coverage, who can help you navigate the process and keep your funds safe.
2. The Same Taxpayer Must Buy and Sell
Also known as the “same taxpayer rule,” this states that the same taxpayer must be both the seller of the relinquished property and the buyer of the replacement property in a 1031 exchange. This applies to both individuals and entities.
For example:
- If Jane Smith is selling a property she owns as an individual, Jane Smith must buy the replacement.
- If Jane Smith owns an LLC called “123 Eagle Rd LLC” and the property is owned by the LLC, then 123 Eagle Rd LLC must buy the replacement property.
You can imagine that with spouses, LLC holding companies, or any sort of “syndicate” investment with multiple owners, determining who the “taxpayer” is may require a little bit of effort. But your CPA or qualified intermediary can easily help you figure this out.
Furthermore, if a property is owned by many shareholders or a partnership, then all parties have to agree to the exchange together. If one partner wants to leave the partnership, there are ways to navigate this, but it becomes complicated and will likely involve hiring an attorney and working with a good qualified intermediary to solve it.
3. The Properties Must Be “Held for Investment”
To qualify for an exchange, the property must be “held for investment.” This means your personal residence will not qualify for a 1031 exchange. It also means that fix-and-flip investments, or other investments generally held for less than one year, likely won’t qualify for an exchange either.
That said, if you’re selling a personal residence, you may be able to use another part of the tax code to defer your gains. The Section 121 exclusion still allows homeowners to realize a portion (or potentially all) of their capital gains on a primary residence completely tax-free. Moreover, if part of your primary residence is used as a home office, you may be able to use the Section 121 exclusion in combination with a 1031 exchange if the gains you’re realizing are larger than the Section 121 exclusion limits.
Based on all this, you might think that vacation homes are excluded from 1031 exchanges as well, but that isn’t exactly true. In fact, if you have a vacation home that you rent out at fair market value for at least 14 days per year for the first two years and your personal use of the property is limited to the greater of 14 days per year or 10% of the time the property is rented out each year, then you can sell your vacation home through a 1031 exchange.
4. The “Equal or Up” Rule
The “equal or up” rule is one of the simplest rules surrounding the 1031 exchange. This rule states to fully defer your capital gains taxes:
- The value of the property you buy must be “equal or up” from the value of the property you sold.
- The amount of debt used in the purchase of new property must be “equal or up” from the amount of debt paid off with the sale of property.
For example, if I sell a $1 million property and pay off a $500,000 loan in the process, then I need to buy a replacement property that’s “equal or up.” There are many ways this could work:
- Buy a new property worth $2 million with a $1.5 million loan—that’s great!
- Buy a new property worth $1 million with a $500,000 loan—right on the money!
- Buy a new property worth $500,000 with no loan—not so much. Your debt amount is not “equal or up,” so your exchange will be taxed.
However, the IRS realizes that this doesn’t always work—sometimes, investors can’t find a property that’s more expensive than the one they have at any given time. This is why they have allowed partial exchanges—this happens when you’re not “equal or up” on both the property value and the debt amount, so only a portion of your capital gains are tax-free.
The math can be a bit more complex with these, so Deferred has put together a great calculator to help you estimate your tax burden if you are doing a partial exchange.
5. Property Identification Rules
Identifying a potential replacement property in a 1031 exchange isn’t as simple as you might think. You can’t just make a mental note of the fact that you would like to consider a property. Instead, you need to spell out in writing the specifics of the property, sign a document that meets certain requirements, and then deliver that document to a designated person (typically, your qualified intermediary).
The biggest restriction, however, limits how many properties you can identify. The IRS doesn’t want you to you have infinite options, so they restrict you to listing some specific properties, and you’re limited on how many you can list. Here are some rules to keep in mind:
- Three property rule: You identify up to three properties as potential replacements without regard to their fair market value. You can then purchase any combination of these properties as a replacement property/properties.
- 200% rule: For those who identify more than three replacement properties, and the cumulative market value does not exceed 200% of the fair market value of the relinquished property, you can purchase any combination of these properties as replacements.
- 95% rule: This is a seldom-used rule—it’s very difficult to comply with. But if you have identified more than three properties and their total fair market value is more than 200% of the value of the property you’re selling, you must acquire 95% of the identified replacement properties before the end of the exchange period. For example, if you identify 10 properties and end up using the 95% rule, you’d need to buy 9.5 of those properties. Practically, if you can’t buy a single one of those properties for any reason, your entire exchange is blown, and you’ll have to pay taxes on your sale.
6. The 45-Day Rule
When it comes to identifying your potential replacement properties, you’re on a rather strict timeline, as you have just 45 days to identify them in a forward exchange. In the case of an improvement exchange, you must identify all the potential improvements that you will make within this 45-day window as well.
It’s important to note that the 45-day window begins the moment you either sell the relinquished property in a forward exchange or purchase the replacement property in a reverse exchange. This timeline then ends at midnight on the 45th day after the initial transaction.
7. The 180-Day Rule
The 180-day rule is rather straightforward: It states that the 1031 exchange transaction must be complete within 180 days of the start date.
In the case of a forward exchange, this means closing on the replacement property within 180 days of selling the relinquished property. With reverse exchanges, this means you must sell the relinquished property within 180 days of acquiring the replacement property.
Lastly, with an improvement exchange, the relinquished property must be sold, and the improvements to the replacement property must be completed and paid for by the end of the 180-day window.
8. Sell First or Buy First—The Order Doesn’t Matter
If you’ve never done a 1031 exchange before, you might be surprised to learn that there are actually several types of exchanges that you can do. Depending on whether it’s a buyer’s or seller’s market, you can do an exchange in any order. Here’s a look at each:
- The forward exchange: This is the most commonly used type of 1031 exchange, where you sell a property, give the proceeds to a qualified intermediary, and then you have 180 days to close on the replacement property.
- The reverse exchange: The reverse exchange is a lesser-known type, where you buy the replacement property first, transfer ownership to a qualified intermediary to hold for you, and you have 180 days to sell the relinquished property.
If it’s a buyer’s market, you may be comfortable with a forward exchange—it may take time to sell your property, and you can probably find a great deal to meet your exchange timelines. If it’s a seller’s market, you may want to find your replacement property first and then do a reverse exchange.
9. Check the Rules for Your State
Another important consideration that’s often overlooked is that you need to check your state’s local legislation on 1031 exchanges. All the aforementioned rules apply at the federal level, but some states have decided to impose their own rules and regulations that you must follow in addition to the federal ones.
Some states, like California, have both high income taxes and complex rules around 1031 exchanges, making the act of doing an exchange in California much more high stakes. On the other hand, states like Nevada have no state income tax and are much less restrictive when it comes to 1031 exchanges.
A good qualified intermediary or CPA can help you navigate these rules.
10. Don’t Get Ripped Off on Fees
Lastly, it’s important to not overpay for a qualified intermediary. It’s a commodity service—there are countless companies that would do 1031 exchanges for a flat fee. While the fee may seem low, they often keep all the interest they earned on your money while it sits in escrow, earning tens of thousands of dollars for larger exchanges.
Most people don’t realize this, but the fees for a qualified intermediary are negotiable. Deferred.com even offers a “No Fee Exchange,” saving the average exchanger $950, by our estimates. Deferred will even split the interest money they earn with you. This means you walk away from the transaction with more money in your pocket than when you began it.
Regardless of who you decide to partner with on your 1031 exchange, be sure that they are a reputable organization. After all, they’re going to be holding on to your money or property for extended periods of time, so they need to be trustworthy.
Some things to look for:
- Ensure that they are responsive by both email and phone.
- Confirm they hold your funds in segregated accounts with FDIC coverage.
- Verify they have E&O insurance and, ideally, a fidelity or surety bond that will protect you from lost funds.
- You can also do due diligence on a company through industry associations, like the Federation of Exchange Accommodators.
Final Thoughts
You’re now that much closer to being a 1031 exchange expert. When it comes time to sell your next investment property, remember these 10 things:
- You can’t touch the money: You must work with a qualified intermediary to hold your funds.
- Be sure it’s the same taxpayer: Property must be bought and sold by the same person or entity.
- Property must be held for investment: The property must be used for investment purposes.
- Equal or up: You must buy a replacement property that is “equal or up” in property value and loan amounts.
- Keep in mind property identification rules: You’re limited in how many properties you can identify as replacements.
- Remember the 45-day rule: You must identify replacement property within 45 days of your sale.
- Remember the 180-day rule: You must purchase all replacement property within 180 days of your sale.
- You can sell first or buy first: You can use a “forward” or “reverse” exchange to complete the exchange in any order.
- Consider state rules: 1031 exchanges are for federal capital gains taxes—each state has its own rules.
Don’t pay fees: Qualified intermediary fees and interest earned on your funds are negotiable.
