A 1031 exchange is a popular way to sell your real estate and exchange it for another piece of real estate without having to pay any tax. The tax deferral allows the taxpayer to invest more of their cash into a new property instead of the alternate scenario of paying taxes on the gain and purchasing a new property.
1031 Exchange Requirements
The process of an exchange has a lot of complications but the basics to qualify for a 1031 exchange and pay no tax are as follows.
- You must purchase a “like-kind” investment in real property
- The replacement property must be of equal or greater value
- You must invest all the proceeds from the sale
- The title holder and taxpayer must be the same
- You must identify the new property within 45 days
- You must purchase the new property within 180 days
Exchanges can also be used to reduce the total capital gain from a sale if a taxpayer wants to buy a smaller replacement property. The general rule is that smaller the reinvestment then the greater taxable gain. As with all things in tax the details matter and each specific situation warrants its own analysis to determine if its tax treatment. While the benefits of a tax-free exchange can be substantial the tax treatment should not be the only thing to consider.
When is a 1031 Exchange a Good Idea?
The decision to make a 1031 exchange should include a total evaluation of the tax effects as well as the economics of the sale. Talking with your financial and or tax advisor about any potential exchanges along the cost benefit should be discussed as each situation has its own merits. While saving money on the sale of a property can make sense for tax purposes, exchanging it for a property which is a bad investment overall leaves you worse off in the long run. The time constraints on a 1031 to identify and purchase can make finding a suitable replacement property a common issue among people during the exchange period.
From a tax perspective, 1031s are the most beneficial when you have a property with a low tax-basis and substantial appreciation. The higher the tax deferral then the more cash that is saved for a replacement property. If the property you are looking to exchange has not appreciated much in value since the initial purchase, a 1031 exchange might not be the best bang for your buck.
As an alternative, a cost segregation study can accelerate the depreciation on new property which can offset the gain from the sale. With this strategy you can buy the second property without the short time constraints of the 1031 requirements. However, the purchase will have to be in the same tax year as the sale for an offset of the gain. This approach would involve a careful review of the details of both transactions to fully determine the tax consequences.
From a nontax perspective you should also consider the economic factors of the replacement property as well. Factors like cash flow, type of property, debt service, and market conditions of the location all play a major role in deciding to purchase real estate besides taxes.
Another opportunity with 1031 exchanges is the opportunity for a multi-property exchange. If the sale is large enough, you can purchase multiple properties with an exchange. Often this is a good strategy to diversify a real estate portfolio as it lets the buyer spread out their real estate investment into different markets and properties tax free. For example, a sale of a commercial building can be exchanged into a residential rental, multifamily complex, or even an interest in a Delaware Statutory Trust (DST).