Real estate investors have a wealth of tax strategies at their disposal. This is one of the primary motivators for investors to choose real estate as their primary asset! We’re here to give you the rundown on one of the most powerful tax-deferral tools at your disposal: The 1031 Exchange.

Summary: A 1031 Exchange defers capital gains taxes through the sale of one investment property and the purchase of another "like-kind" property.

Of course, we’re talking about tax law here, so it’s going to get more complicated than that. Here’s the 4-1-1.

How the 1031 Exchange Works

When you sell an investment property for a profit, you’d normally owe capital gains taxes on that profit.

But with a 1031 Exchange:

• You sell your current investment property.
• Instead of taking the cash, you reinvest the full proceeds into another like-kind investment property.
• You defer the taxes you would have paid on the gain.

To refresh, capital gains taxes are calculated by the net profit from the sale of a house. You subtract the purchase price (and improvement costs) from the final sales price. You’ll be left with capital gains, which are usually taxable.

They may be short- or long-term capital gains, which impact the rate at which your profit is taxed. If you own a property for less than a year, it will be taxed the same as your regular income, depending on your tax bracket. That could be anywhere between 10% and 37%. 

Long-term gains are for properties you’ve owned for at least a year, and they’re taxed at lower rates (between 0% and 20%). 

Bottom line? Deferring capital gains taxes can save you a lot of money.

1031 Exchange Rules

As with all things tax-related, strict rules define how to perform a 1031 Exchange properly. To qualify, the exchange must follow these rules:

Rule #1 – Like-Kind Property

• Both the relinquished and replacement properties must be investment or business properties. You can’t use this strategy for your personal residence, whether buying or selling.
• The properties must be in the U.S.
• "Like-kind" is broad and quite forgiving. You can exchange a single-family rental for raw land, commercial property, or even several single-family properties.

Rule #2 – Timeline 

45-Day Identification Rule: You must identify potential replacement property(s) within 45 days of selling your original property. You’ll want to plan an exchange well in advance.

180-Day Exchange Rule: The replacement property must be closed on within 180 days of the original property’s sale.

Rule #3 – Equal or Greater Value

It’s possible to owe some capital gains taxes in an exchange if there’s leftover cash or discrepancies in the mortgage balances. (This is called “boot,” and it will be taxed as capital gains!) To defer 100% of capital gains taxes, you must:

• Buy a property (or properties) of equal or greater value.
• Reinvest all the sale proceeds.
• Take on equal or greater debt. Lesser debt liability may also be taxed even if you don’t receive any cash in the transaction.

Rule #4 – Qualified Intermediary (QI)

Funds from the sale must go through a Qualified Intermediary (not directly to you). You essentially need a third party to handle the moving of funds so that cash never directly goes into your hands.

The QI holds the proceeds and facilitates the exchange process. Your proceeds are typically held in a Segregated Qualified Trust Account or a Segregated Qualified Escrow Account. Remember, the QI has a fiduciary responsibility to safeguard your money!

The important thing is that the seller (you!) doesn’t have direct access to profits from the sale.

Rule #5 – Title Must Match

The name on the title of the new property must be the same as the one that sold the relinquished property. In other words, if the first property was in your name, you can’t have the second property in the name of your LLC. 

Title owners must be consistent.

When Should Real Estate Investors Use a 1031 Exchange?

When You Want To:

• Defer capital gains taxes to maximize reinvestment power.
• Upgrade to a higher-value property.
• Diversify into different types of properties or markets.
• Consolidate or divide properties (like selling several units to buy one larger property, or vice versa).
• Shift investment strategy, like moving from active to more passive investments.

Want extra information on the 1031 Exchange? Read Use the 1031 Exchange to Maximize Money You've Already Invested!

There’s so much more to cover when it comes to the 1031 Exchange. If you’re interested in employing this strategy for your real estate portfolio but don’t know where to start, never fear—our REI Nation advisors have helped countless investors perform 1031 Exchanges. 
We’ll help you do the same.

Start investing with REI Nation, where you invest and we handle the rest!