Understanding 1031 Exchange and Its Real Estate Tax Benefits

If you’re a real estate investor – or interested in the industry – you understand the lucrative nature of property investments. Buying and selling real estate can generate valuable portfolios. However, property transactions also drive a large tax bill. 

Real estate investors can save money by taking advantage of 1031 exchanges. The IRS allows taxpayers to defer capital gains tax on transactions meeting the 1031 exchange requirements. This article will explain how you can qualify for the tax benefit. 

What Is a 1031 Exchange?

A 1031 exchange is a transaction in which a taxpayer trades a qualifying real estate property for another. A valid 1031 exchange allows the taxpayer to defer capital gains tax on the transaction. The term 1031 exchange is synonymous with the term like-kind exchange. 

The Internal Revenue Code (IRC) Section 1031 rules benefit taxpayers who invest in real estate. The gain – and the tax on the gain – gets put off until the taxpayer sells the property in a non-like-kind (taxable) transaction. The taxable property sale could happen many years later.

The 1031 exchange process generally includes the following steps: 

1. Sell the original property
   
2. Identify potential replacement properties
   
3. Purchase a qualifying replacement property

Importantly, the taxpayer must complete the exchange in a single transaction. The investor cannot receive the sales proceeds before purchasing the new property. A third party, such as a qualified intermediary, must hold the cash proceeds from the sale of the relinquished property. We’ll explain how a qualified intermediary can facilitate a tax-deferred exchange later.

If you receive cash or non-like-kind property in the exchange, the transaction may still qualify for tax deferral. However, you must report and pay tax on the gain from the non-like-kind property.

What Type of Property Can Qualify for a Like-Kind Exchange?

Your property must meet the IRC Section 1031 qualifications to be eligible for a like-kind exchange. 

• You must hold the property for investment or use the property in your business. Your primary residence or vacation home cannot qualify.
  
• Your property must meet the real property definition. Real property includes the following:
  
  • Land, houses, apartment buildings, and hotels
    
  • Permanent structures attached to the property, such as garages, permanent lighting fixtures, and swimming pools
    
  • Real property includes many other asset types. Refer to Treas. Reg. § 1.1031(a)-3: Definition of real property for a comprehensive list. 

Professional CPAs can help you determine whether your property qualifies. 

What Property Does Not Qualify for Tax Deferral?

Like-kind exchanges cannot include cash, stocks, bonds, or other short-term investments. Non-qualifying property generates a taxable gain.

The 2018 tax code changes affected IRC Section 1031. Like-kind exchanges now exclude personal and intangible property, such as the following: 

• Personal property: Machinery, equipment, vehicles, furniture, and similar movable assets
  
• Intangible property: Intellectual property, trademarks, patents, know-how, and goodwill

What Qualifies as Replacement Property?

The replacement property must meet tax code requirements to qualify for like-kind exchange treatment. 

Generally, the qualifying replacement property must be similar in type and nature to your original property. The new property must meet the real property definition and be held for investment or used in your business. Property located outside the U.S. cannot qualify. 

Most real estate exchanges are like-kind. We recommend consulting real estate tax professionals for help with complex rules. 

What Is the Time Limit for a 1031 Exchange?

You must follow strict time limits to defer capital gains tax on your real estate transaction. IRS Publication 544 explains the following rules:  

• Identify the replacement property within 45 days of selling the original property. You or your agent must notify (in writing) the seller of the potential replacement property.
  
• Purchase the replacement property within 180 days of selling the original property. If your tax return is due before the 180-day limit, you must complete the purchase before your return due date (including extensions).

The IRS does not honor any extensions to the time limits. However, investors can use tax planning strategies to structure a delayed exchange or a reverse exchange. Consult with real estate professionals early to avoid losing the tax deferral. 

What Is a Qualified Intermediary?

A qualified intermediary is an unrelated third party who facilitates the 1031 exchange. 

The qualified intermediary must comply with a written contract detailing their responsibilities. The agreement should explain that the qualified intermediary will acquire and transfer your relinquished property. The intermediary must also obtain your replacement property and transfer the new property to you. 

Carefully select your qualified intermediary – the third party cannot act in your interest (or even appear to do so). 

According to the IRS, related party involvement can invalidate tax deferral. For example, the intermediary must not be your immediate or extended family member. You cannot hire your employee, accountant, lawyer, or advisor. 

Tax Benefits of a 1031 Exchange

Capital Gains Tax Deferral

The main advantage of a like-kind exchange is the federal capital gains tax deferral. 

Consider a simplified scenario in which an investor sells a commercial real estate building. The following example illustrates the like-kind exchange tax benefits. 

• Cash proceeds (equal to the building’s fair market value): $10,000,000
  
• Original purchase price: $3,900,000
  
• Cumulative tax depreciation expense: $1,000,000
  
• Tax basis (purchase price less depreciation expense) at sale: $2,900,000
  
• Capital gain (cash proceeds less tax basis): $7,100,000
  
• Long-term capital gain tax rate (2024): 20%
  
• Capital gains tax (capital gain x 20%): $1,420,000

The above transaction results in a $1,420,000 tax liability for the investor – due in cash! 

However, if the same investor completed a 1031 exchange, the transaction would not generate capital gains tax. The investor could defer tax payment until selling the property for cash. 

Depreciation Recapture and Net Investment Income Tax Deferral

Depreciation recapture and net investment income tax represent additional liabilities that could apply to real estate transactions. Due to the capital gain deferral, 1031 exchanges allow deferral of depreciation recapture tax and net investment income tax.

State Income Tax Deferral

Depending on state-specific rules, 1031 exchanges can grant state income tax deferral. Many states follow the federal like-kind exchange treatment and defer the capital gain. 

However, be aware that certain states impose complex laws. For example, California and Pennsylvania enforce state-specific rules for 1031 exchange transactions.  

Non-Tax Benefits of a 1031 Exchange

Like-kind exchanges offer economic benefits due to the favorable federal income tax treatment. Real estate investors can enjoy non-tax advantages and further their portfolio growth. 

Portfolio Consolidation

Property owners with vast investment property portfolios can use 1031 exchanges to consolidate investments and reduce administrative responsibilities. For example, if an investment firm owns 12 properties, the company could exchange several buildings for a single property. The investment firm would ultimately manage fewer assets.

Investment Diversification

Investors can use like-kind exchanges to expand into new markets or geographic regions. Tax savings can help investors afford higher-priced rental properties in growing neighborhoods. 

Estate Planning

Like-kind exchanges promote tax-efficient growth of generational wealth. If an investor passes on a property through an estate, the inheritor gets an increased tax basis. If the inheritor ultimately sells the property, they will report a lower capital gain due to the increase in basis.  

Trading Up

Investors can use like-kind exchange tax savings to purchase real estate with a greater value than the original property.

Cash Flow Improvement

Like-kind exchanges help property owners improve cash flow. Taxpayers can avoid costly capital gains tax payments and pay lower taxes.

1031 Exchange FAQ

How Do 1031 Exchange Rules Apply to LLCs?

LLCs and all other entity structures are eligible for like-kind exchange tax benefits. Any entity type can defer capital gains taxes by following the IRC Section 1031 exchange rules. 

How Do I Report a 1031 Exchange on My Tax Return? 

Use IRS Form 8824, Like-Kind Exchanges to report a 1031 exchange. Taxpayers must provide information about the original and replacement properties. The form provides a step-by-step gain calculation to support capital gains tax deferral. 

What Is the Downside of a 1031 Exchange?

Real estate investors must follow strict rules and time limits to qualify for tax-deferred exchange tax benefits. Inexperienced taxpayers can make mistakes and inadvertently cause taxable transactions. Real estate tax professionals can help property owners with tax planning strategies.

Is the Like-Kind Exchange Worthwhile? 

Like-kind exchanges require diligence and planning, but real estate investors can enjoy savings on deferred-tax transactions. We recommend consulting tax advisory professionals who offer personalized tax planning assistance.  

Let 1-800Accountant Support Your Real Estate Tax Planning

The 1031 exchange offers generous tax benefits for real estate investors. You can use the like-kind exchange to generate tax savings on your real estate investments. 

1-800Accountant offers real estate tax advisory services to help grow your investment portfolio. Professional CPAs support your business with tax advice and planning strategies. We’ll help you understand how the rules apply to you so you can maximize your growth. 
Schedule a free consultation with 1-800Accountant to learn how to defer taxes and comply with complex rules.