What Is a 1031 Exchange and Why Is It Important?

A “1031 exchange” is the nickname used to discuss Section 1031 of the U.S. Internal Revenue Service’s tax code. This section states that if an individual exchanges one investment property for another via a 1031 exchange, they may be able to defer capital gains (or losses) that they would otherwise have to pay at time of sale.

Section 1031 applies to “property” beyond real estate, but many 1031 cases deal with buildings and land. We’ll only discuss 1031s in relation to real estate.

Why Is a 1031 Exchange Important?

So why is a 1031 exchange important? It allows real estate investors to defer paying capital gains and potentially build wealth through real estate investing.

Think about it this way. If you buy a piece of real estate for $100,000 and then sell it for $500,000, you are subject to paying capital gains taxes on your $400,000 profit. From that $400,000, you would lose, say, $120,000 to capital gains taxes. With a 1031 exchange, you might be able to use the $500,000 to purchase one or more new properties and pay no capital gains taxes at the time of sale. The sale’s proceeds fund new investment properties, which in turn may generate cash flow and appreciate.

While you’ll eventually have to pay taxes when you sell these new properties, you may be able to make your money go further using a 1031 exchange. These exchanges matter because they can help real estate investors create more wealth. Investors may use 1031 exchanges throughout their careers to buy bigger or better properties and potentially reap the rewards.

Types of Properties That Qualify

What types of properties quality for a 1031 exchange? The short answer: it depends. That’s because the language used in the tax code is vague. Properties must be, it says, “like-kind.” Says the IRS

“Both properties must be similar enough to qualify as ‘like-kind.’ Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.”

Are you confused about exactly what “like-kind” means? You’re not alone. Says tax expert Robert Wood

“Most exchanges must merely be of ‘like-kind’–an enigmatic phrase that doesn’t mean what you think it means. You can exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another. But again, there are traps for the unwary.”

This is why it is essential to secure professional help if you’re considering a 1031 exchange—there are pitfalls aplenty even for seasoned investors.

Restrictions on 1031 Exchanges

Investors must consider additional restrictions beyond the definition of “like-kind.” A tax professional will illustrate each one, but a few major considerations include:

You must own the real estate. Owning a share in a REIT, a fund or an LLC that owns a share in another LLC does not qualify.
You can only perform a 1031 exchange between investment properties. You can’t do this with personal property.
If you exchange for a cheaper property, you’ll face tax considerations around the price difference.
You can “delay” your exchange (which most people do), where a third party acts as an intermediary between you and a prospective future buyer.

While you can delay the exchange, there are important timing restrictions on the deal. Says the IRS:

“The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.”

There’s a second deadline, too. The “property must be received and the exchange completed no later than 180 days after the sale of the exchanged property.”

As you can see, 1031 exchanges offer immense benefits. But their execution is tricky. Plenty of caveats wait to ensnare investors. If you don’t get the whole deal right, you may end up paying taxes on the entire sale.