1031 Exchanges: What They Are and Why You Should Consider Them

You’ve likely seen in the news or heard from other investors that there’s so much equity in properties to be had right now. The truth is that it’s a great time to invest in real estate. 

But the question is this: Why should you consider real estate? The answer that may surprise you is taxes. 

As doctors, we love to talk about tax strategies. How can I save more next tax season? What other strategies can I use to keep more of my income in my pocket? The pains of tax season can be cured by investing in real estate and taking advantage of a lot of the tax breaks they offer. A powerful tax advantage in real estate is the 1031 exchange. 

You could be in a perfect position to use a 1031 exchange to turbocharge your financial goals. It’s a tax strategy that can be crucial for building wealth and impacting your future as an investor and/or entrepreneur. 

Exchanges carry some tax-efficient strategies that can potentially offset capital gains and put more money back in your pocket come tax season. Saving, investing, and compounding your income nets you more opportunity to do what you love to do: vacations, time with the family, your passions, or any goals worth your time and money.

But are they too good to be true? Today, we’ll learn about 1031 exchanges, how they relate to your real estate investments, and how you can use them to put more income back into your pocket!

What Is a 1031 Exchange and How Does It Work?

As a tax strategy, a 1031 exchange allows real estate investors to defer any capital gains taxes on the sale of an investment property when another, like-kind property is purchased. It’s a legitimate provision in the US tax code (Section 1031) which allows you to essentially swap one investment property for another without paying any capital gains. 

There are some rules and restrictions to what sorts of assets you can use the 1031 exchange for. For example, the new property must be used for business or investment purposes. With delayed exchanges—the most common type—the new property must be identified as a target for a 1031 exchange within 45 days of the sale of the old property. Further, the new investment property must close within 180 days from when you closed on the sale of relinquished property. Make sure you work with your Real Estate Agent, CPA, and financial team to do your due diligence on whether exchanges are right for your financial plan. 

When you initiate an exchange, you’ll report to the IRS with Form 8824. But don’t get me wrong. Whenever I talk about taxes, I need to be clear: I’m not a tax professional. I just utilize the strategies I learn from my own tax professionals. Always consult your CPA or financial team so that your investment choices are relevant to your financial goals.

What Is a Like-Kind Property?

A like-kind property can be characterized as two real estate assets that can be held for investment, trade, or business purposes of a similar nature. Usually that means the newly purchased investment property must be of equal or greater value than the sold or relinquished property.

“Like-kind” doesn’t mean it has to be an exchange of the same asset class. Sure, you could trade a single-family home for a single-family home. But you can also trade a multifamily property for land, land for industrial or office space, industrial for mineral rights, or anything in between. However, ensure that the relinquished and replacement properties meet the requirements for a tax-deferred exchange. 

There are a few restrictions. For example, the new investment property cannot be a primary residence, and it must be within the United States.

The Benefits of Like-Kind Property Investing

By delaying your capital gains taxes, you’ll have more money now to invest how you want. The compounding power of tax-deferred investing gives you the opportunity to skyrocket your portfolio’s performance and more easily access your financial goals. 

Another fantastic aspect to this strategy is there are no limits to the number of exchanges you initiate. That means you can consistently increase the value of your real estate investments while deferring your capital gains. You could start with a single-family home, exchange it for a duplex, then trade for a multi-family, and end up with an even larger multi-family complex. 

And for those looking to build a legacy, 1031 exchanges have major benefits for heirs—an opportunity for creating generational wealth. There’s what is known as a step-up in basis for heirs of real estate investments when the property owner dies. What is the step-up in basis? That means anybody inheriting your property will “purchase” it (inherit) at the property’s appraised value the moment they inherit it. That would wipe out all of the taxes the original owner would otherwise owe from capital gains and appreciation. They could sell the property that day, tax-free. 

Types of 1031 Exchanges

Delayed Exchanges

Just like the name suggests, these 1031 exchanges give you 45 days to find a replacement property and 180s to close on that new investment. They typically occur when the relinquished property is already sold and closed before the new investment property is purchased. 

The major advantage of this type is that it gives you more time to find your new investment property. And finding the right property to swap can prove to be difficult. It may not surprise you that, because of this time advantage, this is the most common type of exchange.

Intermediary Exchanges

In the case of intermediary exchanges, a Qualified Intermediary (QI) helps the investor initiate and carry out a timely 1031 tax-deferred exchange. They create and maintain the exchange and legal documentation, hold the exchange proceeds in an escrow account, and work with the title company. 

QIs aren’t always required, but they do provide many advantages. In some cases, such as an exchange that includes more than three parties, QIs are a required part of the process. They are a neutral party whose only incentive is to do a good job for their clients, earning their exchange fee.

Other, Less Common 1031 Exchanges

Sometimes, you may decide to initiate a partial 1031 exchange, which allows a property owner to defer paying taxes on a portion of the capital gains from the sale of their property. 

There is also a simultaneous 1031 exchange, also known as a “drop-and-swap” exchange, where the closing of the relinquished property and the replacement property occur on the same day. This helps an investor reinvest their money quickly without delaying the process for 45 or 180 days like with a delayed exchange. As can you imagine, though, a simultaneous exchange can be very difficult and complex to coordinate. 

With a reverse 1031 exchange, an investor would purchase the replacement property first, before selling the existing property. This option requires that the investor have the finances to purchase the replacement property without having the proceeds from the sold property. The major benefit here is it gives the investor the opportunity to set up an exchange without needing to start by selling existing property. 

Finally, there’s a specialized type of exchange called the construction or improvement 1031 exchange. Construction exchanges allow the investor to use exchange funds to construct a new property, whereas improvement exchanges allow investors to use some of your exchange funds to make improvements on an existing property. 

Each of these less common 1031 exchanges can access more advanced tax strategies. We’ll discuss that in more detail in an upcoming blog.

Acquiring Like-Kind Investments

When you are ready to get started, identify a property that works well as an investment but also aligns with your financial plan. I write quite a bit about what makes a good investment property, but some key things to think about are asset class, location, and due diligence. 

Know your timelines. Timelines indicate when specific parts of the buying and selling process trigger. If they are missed, you may lose out on the entire exchange. 

If you utilize the services of a QI, make sure you choose the right one. One method is to ask your colleagues with experience in 1031 exchanges which QI they went with. You can also engage in your investment communities to crowdsource a QI with a strong reputation. 

When you find one, do some due diligence before moving forward. Do they have prior real estate experience? Have they completed compliance exams, such as the SSAE 16? Do they allow regular access to funds? Will your funds be FDIC-insured?

When to Use a Tax-Deferred 1031 Exchange

The time is right for a 1031 exchange when the new property has a better return on investment (ROI) than the existing property (or properties). 

But there are other considerations on timing. If you are holding onto multiple properties you want to exchange together for something bigger, you can consolidate multiple real estate properties in a single exchange. And the reverse is also true: It might make sense to sell one of your current properties to invest in several new properties. 
Exchanges can also act as a hedge against a bad investment. You may have a rental property experiencing unexpected depreciation. One way to reset that investment? A 1031 exchange. It’s a way that the IRS allows you to write off a lot of value—what’s called “paper losses.”

Unlock the Power of the 1031 Exchange

With a little more understanding of 1031 exchanges, I hope you feel more comfortable when considering them as a powerful investment and tax-deferring strategy. I’ve used them, and they’ve greatly enhanced the performance of my investment portfolio. 

But this isn’t the end of our discussion on 1031 exchanges. Keep an eye out on this blog. Soon we’ll dig deeper into specific kinds of 1031 exchanges and advanced strategies for how you might use them as an investor. That will include more fine-tuned tax implications. 

Until then, I hope to see you engaged in our communities here at Passive Income MD as you keep investing to achieve your ideal life!
Peter Kim, MD is the founder of Passive Income MD, the creator of Passive Real Estate Academy, and offers weekly education through his Monday podcast, the Passive Income MD Podcast. Join our community at the Passive Income Doc Facebook Group.