How Does 1031 Exchange Work?

two individuals doing a real estate transaction

Real estate investment is a path to wealth, but with it come capital gains taxes that cut into your funds. 

The federal government taxes capital gains as much as 20 percent, depending on your tax bracket and how long you’ve held assets. Most states have their own capital gains taxes on top of that. With every lucrative sale, investors owe a hefty check to the government. 

However, there’s a way to defer such payments. Section 1031 of the U.S. Internal Revenue Code covers “like-kind” property exchanges. It allows you to convert one real estate sale into the purchase of similar property, while deferring the taxes on that sale. 

The 1031 exchange, sometimes called a Starker exchange, is something of a legal loophole, and it’s one of the most powerful—if not the most powerful—tools available to real estate investors. 

But it’s not something just anyone can do. The parameters are strict, and you need an experienced intermediary to handle the intricate details of the exchange. Otherwise, you may be stuck with an unwelcome tax bill.

1031 Exchange Explained

The 1031 exchange is meant primarily for real estate transactions where the purchase price of the new property meets or exceeds the sales price of the relinquished property. 

The like-kind clause means the following for investors: 

  • It rarely applies to personal property (the exceptions involve stipulations on time spent renting the property). 
  • You can’t use a 1031 exchange when selling commercial property and purchasing property for personal use. 
  • The investments must be of the same nature or character—you can’t exchange real estate for an art collection, for example. 
  • You can, however, exchange land for buildings, so long as both were held for investment purposes. 

There’s also a stringent deadline. When the initial sale is made, you have 45 days to identify replacement property of equal or greater value, and 180 days to close on those properties. 

The pressure is on immediately, intentionally so. 

Where a Qualified Intermediary Helps You

Consider the most basic 1031 exchange scenario. You’ve invested in a rental property and held it for several years. It’s a high-maintenance building, but it’s appreciated in value, making it prime for an upgrade. 

You find a buyer and go about setting up a 1031 exchange. Once the sale is finalized, the money goes directly to a qualified intermediary. 

Over the next 45 days, you identify up to three new properties that fit the 1031 exchange parameters and submit them in writing to the intermediary. You then have the remaining days—note that the 45-day identification period and 180-day closing period run concurrently—to close on the new property, at which point the intermediary provides the funds for the purchase. 

Because the money goes through a third party, you defer the capital gains tax until you cash out your real estate investments for good. 

Of course, it’s never that simple. Finding like-for-like properties is no guarantee, not to mention navigating the minutiae of tax law when ‘boot’ (a sort of implied income) and depreciation factor. 

Besides, 1031 exchanges involve huge sums of money. You need to trust someone to be responsible with it and provide the right guidance to fit the criteria. 

There are also different kinds of exchanges that intermediaries can walk you through. For example, through a reverse exchange, you can close on a new property before selling a current one. In that scenario, you’d shift the title claim of the planned relinquished property to the intermediary as you assume ownership of the new one. When you lock in a buyer, the intermediary would handle the sale and transfer title within the 180-day time frame. 

1031 exchange is a valuable investment tool, but only if it’s done right. That’s where the professionals come in. They can help you execute multiple transactions throughout your investment life—without limit. Find out how the experts at Surety can take your real estate investments to the next level.