1031 Exchange Basics

In a 1031 exchange, the owner of an investment or business property exchanges one property for another. The replacement property is generally of equal or greater value.

When you exchange a property, any capital gain that you’d normally incur is passed on to the next property, so you won’t have to pay taxes until the replacement property is sold.

This means a 1031 exchange can be used to defer taxes, not avoid them forever. It’s an economic incentive — not a tax loophole.

The IRS allows 1031 exchanges because they incentivize real estate investors and business owners to scale up their business by buying larger, more valuable properties. 

For a 1031 exchange to be valid, a qualified intermediary must hold onto the proceeds of the sale until the money can be transferred to the seller of the new property. 

To report the exchange to the IRS, you need to file Form 8824 with your tax return.

What is a like-kind property?

Any property that is exchanged in a 1031 exchange must be “like-kind.” So what does that mean, exactly?

According to the IRS, “like-kind” means that the properties are of the same nature or character, not necessarily the same grade or quality.

For example, one apartment building could be exchanged for another — even if the two buildings are very different in terms of their value, condition, features, etc.

To take it a step further, you could even sell a vacant piece of commercial land and exchange it for an office building since both are real estate.

Any property that’s located outside of the United States cannot be considered “like-kind” to property that is located within the U.S.

While finding a “like-kind” property can place some limits on your 1031 exchange, there’s actually more leeway here than most people realize, so “like-kind” can be a misleading phrase.

 

What is the “boot?”

“Boot ” or “mortgage boot” is a term that is commonly used in the context of 1031 exchanges.

It’s not a technical term that the IRS uses, but it’s a reference to any cash received in the exchange that is not reinvested in the replacement property.

One way that this may occur is if the mortgage for the new replacement property is less than the mortgage that was paid off when the original property was sold.

For example, if the balance of the mortgage on the original property was $100,000 at the time that you sold, and the mortgage that you needed for the replacement property was only $80,000, the "boot" would be $20,000.

This reduction in debt is viewed as a taxable cash benefit that will be taxed as a capital gain.

 

Why would you use a 1031 exchange?

 

There are three important reasons why a smart business person or real estate investor would use a 1031 exchange:

Defer capital gains

The primary reason for using a 1031 exchange is to defer payment of taxes on your profits. Typically, when you sell a property, you’re taxed on your capital gain in the sale —the difference between what you paid for the property and what you sold it for.

Capital gains tax can add up quickly, particularly if you’re selling a valuable property or a property that has greatly appreciated in value while you’ve owned it.

Capital gains consist of Federal and state taxes, but there's also depreciation recapture (which we'll talk about in a minute) and Net Investment Income Tax (NIIT) of 3.8% which can come into play if you're income is above the IRS threshold.

For now, let's look at capital gains since this makes up the largest portion of taxes in most real estate transactions.

If you purchase a four-unit residential property in California for $250,000 and then sell it ten years later for $400,000, you will have a capital gain of $150,000.

But let's say you've claimed $30,000 of depreciation over the ten year period, and you have eligible closing costs of $5,000. Given these assumptions, your actual gain is $175,000.

When we crunch the numbers and add up Federal capital gains tax (15%), California capital gains tax (13.3%), and depreciation recapture (25%), you're on the hook for $52,525!

But, with a 1031 exchange, you could defer that hefty tax bill by acquiring a replacement property of equal or greater value.

 

In some cases, you may never pay capital gains at all!

When the replacement property from a 1031 exchange is sold, capital gains tax is calculated using your original deferred gain, plus any additional gain that has been realized since you purchased the new property.

However, there’s one exception to this rule. If you die before selling a property that was acquired in a 1031 exchange, the government will forgive the capital gains tax.

This means that, theoretically, you could perform several 1031 exchanges in your lifetime to increase the value of your investment property, without ever paying capital gains tax! For this reason, 1031 exchanges have interesting estate planning possibilities.

We’re not tax professionals, so make sure you talk to an accountant to find out if a 1031 exchange makes sense for you.

 

Avoid depreciation recapture

Landlords are allowed to record depreciation in the value of their investment properties to offset their income tax.

In reality, most properties appreciate in value over time, but because an investment property is a business asset, depreciation is allowed because it’s assumed that there will be wear and tear from tenants.

However, when you go to sell an investment property and there’s a gain, the depreciation that you recorded during your years of ownership gets “recaptured” by the IRS — meaning that the total depreciation you recorded is taxed.

To sidestep depreciation recapture, some landlords use a 1031 exchange so that they can build their portfolio without getting hit by the depreciation that they’ve been benefiting from for years.

Depreciation recapture will eventually come into play if the replacement property is sold.

Leverage equity

By exchanging a property that you already own for one (or several) that could increase your cash flow, you’re essentially “leveling up” your investment.

Every new purchase has a cost, but by filing for a 1031 exchange, you can minimize the cost and possibly improve your upside.