If you’re a real estate investor hoping to expand your portfolio, you may want to consider a 1031 exchange. A 1031 can be a great way to purchase commercial real estate without having to immediately pay the properties’ capital gains taxes. By saving money on your taxes, you can use the funds to invest further, make improvements to the property, or consolidate your portfolio. But how do you know if a 1031 is your best option? We’ll explain what a 1031 is, how it works, and whether or not it’s a good investment for you.
What is a 1031 Exchange?
A 1031 Exchange gets its name from Section 1031 of the U.S. Internal Revenue Code. It’s a type of purchase that allows real estate investors to swap one business investment property for another, but in a tax-deferred way. When making the switch, a 1031 lets you defer capital gains taxes you’d otherwise need to pay during the sale. And since you aren’t required to pay the taxes on your property yet, you can use that money to continue investing. The amount you can save will depend on mortgage rates, property taxes, and sales prices. You can use this calculator from Mortgage Calculator to figure out how much you can save.
A 1031 Exchange only applies to business and commercial real estate that are considered “like-kind.” For this reason, a 1031 exchange is sometimes called a like-kind exchange. However, the definition of “like-kind” for real estate investments is relatively flexible. NerdWallet explains that like-kind doesn’t have to be an exact exchange–for example, one apartment complex for another. Instead, it usually means one investment property for another investment property. The replacement property also needs to be of equal or greater value to the property you wish to sell.
Who is a 1031 Exchange For?
For those who are interested in growing their real estate investment portfolio, and want to take advantage of the tax-deferred status of this type of exchange, a 1031 can be a good investment choice. 1031s are especially popular among investors who hope to upgrade their properties without being taxed for the proceeds. Usually, these exchanges are done with commercial real estate or business properties.
While these exchanges can be a great way to invest, there are several rules that go into a 1031 exchange—more than your average commercial real estate loan or investment. For that reason, we recommend working with seasoned and qualified intermediaries. Not only will they hold your funds until the trade is complete, but they can also help you make wise investment decisions and keep track of deadlines during the exchange.
How to Use a 1031 Exchange
There are three main types of 1031 exchanges. Each are tax-deferred, but they all have their own unique sets of rules to follow.
- A delayed exchange is the most common 1031. You get a maximum of 180 days to purchase a like-kind property you’ll use to make the exchange. If your property is sold before those 180 days, the cash goes to your intermediary. The intermediary holds the funds until you find a replacement property.
- A built-to-suit exchange is also called an improvement exchange or a construction exchange. In this type of 1031, you use the deferred taxes to make improvements on the replacement property. Similar to a delayed exchange, you get 180 days to complete the improvements.
- A reverse exchange is when you close on a replacement property before closing your sale on your relinquished property. This is a great option for seller’s markets or when you need to close quickly and/or outbuy any competition.
When Should You Use a 1031?
Some of the times you may choose to use a 1031 may include:
- Resetting your property’s depreciation
- Investing in a property with better returns than your current investment
- Selling your investment property so you can invest in more properties
- Consolidating multiple properties into one, usually for estate planning purposes
How to Do a 1031 Exchange
To ensure you get the most out of your tax-deferred property investment, here’s a step-by-step guide on how to complete a 1031.
- Identify the properties you’re interested in selling and buying. Remember, they must be considered “like-kind,” even if they aren’t the same quality. You’ll typically have 45 days to sell the property, and you’ll need to close on the new property within 180 days. You can learn more about the deadlines in this Investopedia article.
- Select your intermediary. This person will handle the exchange and hold your funds until the exchange is finished. They will remind you of key deadlines and ensure your funds are secure while making the exchange.
- Select how much of the sales proceeds will go toward the new property. Usually, the amount you reinvest is considered tax-deferred. If you keep some proceeds, you may still end up owing some capital gains tax.
- Finally, you will need to tell the IRS about the transaction. You’ll do this through filing IRS Form 8824 with your tax return.
Interested in investing? Fill out our form to see if you qualify for a 1031 real estate loan, and one of our experts will get back to you shortly.
As a community bank, we are actively seeking ways to enrich the lives of our customers and our communities. We seek to share this solely for informational purposes and this information is not a substitute for legal or tax advice. Crews Banking Corporation, including Charlotte State Bank & Trust, Crews Bank & Trust, Englewood Bank & Trust, and Wauchula State Bank, and its representatives are unable to provide legal or tax advice. Please consult an appropriate advisor regarding any legal or tax consequences.
About the Author
One of Southwest Florida’s leading business bankers, Todd joined the Crews Family of Banks in March of 2019. He has experience in all aspects of the banking industry, earning a reputation for providing exceptional service to his clients.
Todd started his banking career in 1978 while still in high school in Cape Coral, working part time as a high school cooperative education student while attending school full time. His positions have ranged from branch manager to senior vice president and senior lending officer. He has a thorough working knowledge of lending fundamentals, credit analysis, interest rate risk, and financial regulatory management and reporting.
Todd graduated from the Florida School of Banking at the University of Florida in Gainesville in 1991 and the Graduate School of Banking at the University of Colorado in Boulder in 1997. He earned a bachelor’s degree in business management at Barry University in Miami Shores, Florida, in 1999.
A former chairman of the Cape Coral Chamber of Commerce, Todd serves as scholarship director for the Southwest Florida Junior Golf Association. He has been a board member of the Rotary Club of Cape Coral and a Big Brothers/Big Sisters of Southwest Florida volunteer.