Many savvy investors use 1031 exchanges to save on taxes and continue building wealth through commercial real estate.

But taking advantage of this strategy requires understanding a complex set of terms and rules, as well as enlisting professional help to complete the process.

Here’s what you need to know.

What Is a 1031 Exchange?

Since 2018, this tax provision only applies to commercial real estate.

Normally, when you sell a piece of commercial real estate for more than you bought it, you owe capital gains tax to the IRS and possibly to your state.

For example, if you bought an investment property for $500,000 and sold it for $750,000, you would owe a certain percentage on the $250,000 difference. Plus, if you had claimed depreciation for that property on your annual tax returns, you would likely owe depreciation recapture taxes as well.

However, if you’re selling a commercial property in order to buy a different one, you may be able to use a like-kind exchange under Internal Revenue Code Section 1031 – aka a 1031 exchange or Starker exchange – to defer those tax payments until the replacement property is ultimately sold for cash.

What Are the Benefits?

The potential advantages of a 1031 exchange include:

• Increased cash flow
• Accelerated asset accumulation
• More flexibility to adjust your role as a landlord
• Greater nimbleness to consolidate or diversify your holdings
• Additional income tax savings by resetting the depreciation clock
• The possibility of indefinite tax deferral through continual reinvestment in real estate

Does My Property Qualify?

First, it’s important to note that, since 2018, this tax provision only applies to commercial real estate. Primary or vacation homes you don’t rent out, and other types of personal or business property (like art, collectibles, vehicles, machinery, or patents), are not eligible.

The term “like-kind” has also been a source of confusion for many investors. It doesn’t mean that you have to swap one property for another with the same function – like one duplex rental for another duplex rental. Generally speaking, any deeded real estate that is located in the U.S., that you don’t live in, and is held for use in business or for investment can qualify. That includes buildings as well as vacant land.

In order to defer the entire amount of capital gains tax, your replacement property must be of equal or greater value. If you’re downsizing rather than trading up, you may owe tax on the “boot,” which is the amount you receive from your sale that you’re not reinvesting in a replacement property. (Mortgage reduction and non-transaction costs can also result in taxable boot, even when you don’t actually get cash back.)

How Does It Work?

A 1031 exchange may be structured in a variety of ways, but all of them are subject to nonnegotiable time constraints. Here are the four main types to consider:

1. Delayed exchanges are, by a wide margin, the most common form of 1031 exchange today. After relinquishing your original (“downleg”) property, you must identify a replacement (“upleg”) property in writing within 45 days and close the sale within 180 days (inclusive of the identification period).
2. Simultaneous exchanges occur when your downleg and upleg properties close on the same day. In rare cases, these are performed by two property owners who simply agree to swap deeds. More often, these involve three parties plus an intermediary who facilitates the deal.
3. Reverse exchanges are when you buy an upleg property before selling your downleg property. These are more complicated, because either your upleg or downleg property must be “parked” with an Exchange Accommodation Titleholder (EAT) for up to 180 days until both sales go through. The 45-day rule applies, too.
4. Improvement exchanges allow you to sell your downleg property and use those tax-deferred proceeds to buy and fund construction or improvements on an upleg property. All capital improvements must be completed within 180 days, during which an EAT will hold title to the property.

Who Should I Work With?

For nearly any 1031 exchange, you’ll want to work with a Qualified Intermediary who can coordinate all these moving parts and ensure compliance with IRS deadlines and filing requirements. In some cases, a QI may also hold proceeds or property in escrow.

QIs play a pivotal role, but they aren’t regulated or licensed like many other financial professionals. That’s why it’s essential to work with someone who has verified experience, knowledge of the local real estate market, and good communication skills. And if they’re handling your money, make sure it will be held in FDIC- or NCUA-insured accounts.

Get a Leg Up

When you’re ready to take the next step in your real estate investment journey, consult your financial institution.

 

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