The Rules of a 1031 Exchange: How to Defer Taxes and Grow Your Portfolio
A 1031 exchange is one of the most powerful tools available to real estate investors, allowing them to defer capital gains taxes by reinvesting proceeds from the sale of one property into another. However, to take advantage of these tax benefits, investors must strictly follow IRS guidelines. Below are the essential rules that govern a successful 1031 exchange.
1. Must Buy Property of Equal or Greater Value
To fully defer taxes, the replacement property must be of equal or greater value than the property being sold. If the new property is purchased for less, the difference—known as “boot”—becomes taxable.
Example:
- Selling for $1 million? You must reinvest the full $1 million (or more) into the new property to defer all taxes.
- Buying a property for only $900,000? The remaining $100,000 is subject to capital gains tax.
2. Must Use All Sales Proceeds From the Sale
To maximize tax deferral, investors must reinvest all net proceeds into the new property. If any cash is taken out of the transaction, it will be taxed as capital gains. Any uninvested portion of the proceeds (boot) will trigger a tax event.
3. Must Use a Qualified Intermediary (QI)
The IRS requires that a Qualified Intermediary (QI)—also known as an exchange facilitator—holds and transfers all funds during the exchange process. The seller cannot receive or control the proceeds, or the exchange will be disqualified. A QI ensures compliance with IRS regulations. Taking control of the sale proceeds—even temporarily—voids the 1031 exchange and triggers immediate tax liability.
4. Must Use the Same Entity to Buy and Sell
The same taxpayer or entity that sells the original property must purchase the replacement property. This rule applies whether the owner is an individual, LLC, partnership, or corporation. For example, if ABC LLC sells a property, ABC LLC must also acquire the replacement property. A property sold under an individual’s name cannot be repurchased under a newly formed LLC without violating this rule.
5. Must Identify a Replacement Property Within 45 Days
Investors have 45 days from the sale date to identify potential replacement properties in writing and submit the list to their Qualified Intermediary. The exchanger can choose which rule to use for their identification.
Identification Rules:
- Three property rule: Up to three properties can be identified, regardless of value.
- 200% rule: More than three properties can be identified only if their combined value does not exceed 200% of the relinquished property’s value. So if one sells for $1M, then the exchanger can identify $2M worth of property.
- 95% Rule: This rule does not limit the amount of property nor the number of properties that can be identified. However, the exchanger must close on 95% of whatever is identified.
6. Must Close on the New Property Within 180 Days
The exchange must be fully completed within 180 days of selling the original property. If the purchase is not finalized within this window, the exchange fails, and capital gains taxes become due.
Key Deadlines:
- Day 0: Close on the sale of the original property.
- Day 45: Identify the replacement property in writing.
- Day 180: Close on the purchase of the new property.
7. The Replacement Property Must Be “Like-Kind”
1. The new property must be “like-kind”, meaning it must be held for investment or business purposes. Fortunately, the IRS defines “like-kind” broadly, allowing flexibility in asset types. So one can sell a single family rental and exchange into a multifamily property, commercial asset, raw land, or self storage, for example. One cannot 1031 exchange a personal residence or second home.
Final Thoughts
A 1031 exchange is an excellent strategy for deferring taxes, preserving capital, and growing your real estate portfolio, but strict IRS rules must be followed. Using a Qualified Intermediary, adhering to the timeline, and ensuring compliance with property value, reinvestment, and entity structure are critical to executing a successful exchange.
By structuring your 1031 exchange correctly, you can defer taxes and scale your portfolio strategically. It is important for the exchanger to work closely with their tax advisor and communicates with their 1031 broker and qualified intermediary.
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Disclosure
1031 Exchange Risk
Internal Revenue Code Section 1031 (“Section 1031”) contains complex tax concepts, and certain tax consequences may vary depending on the individual circumstances of each investor. RM Securities and its affiliates make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about the tax aspects with respect to your particular circumstances. Please note that RealtyMogul does not provide tax advice.
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