What You Need To Know About 1031 Exchanges

Real estate investors have been leveraging 1031 exchanges, also known as like-kind exchanges, for over a century as a legitimate tax deferment strategy.

The Revenue Act of 1921 helped establish like-kind exchanges under the IRC Section 1031 tax code, as a valuable provision to which property owners can defer capital gains taxes on a sold property provided and use the funds to acquire a new property of equal or greater value in a designated period.

Like-kind exchanges are so popular that a recent study conducted by Ernst and Young and partners found that these transactions contributed around 55.3 billion to the U.S. GDP in 2021(The DI Wire). In fact, between 2016 and 2019, 12% of all sales were 1031 exchanges, with 52% of those sales being residential (National Association of Realtors).

Nevertheless, the 1031 exchange process can be quite complex. If not done correctly, it can have serious legal and tax consequences.Doorvest has helped thousands of real estate investors navigate the exchange process. If you are considering using this powerful portion of the tax code, here is what you need to know.

How Does a 1031 Exchange Work?

A 1031 exchange has a lot of moving parts that you will want to fully understand before you attempt to use this provision of the tax code to your advantage. There are several rules and important deadlines that need to be met.

Step 1 - Identify the Property You Wish to Exchange

At a base level, a 1031 exchange allows you to swap like-kind commercial or investment properties. That means your first step in the process will be to identify which property you want to sell.

If you intend to swap a second or vacation home, there could be special rules on how you can use the property once the exchange has been completed. There are also restrictions on when you can occupy a swap property if you plan to convert it into your primary residence.

Step 2 - Find a Property You Want to Purchase on Doorvest

Once you’ve identified the property you want to sell, you will need to find a subsequent like-kind property you wish to purchase. This property should have similar characteristics and be located domestically, within the United States.

Step 3 - Contact Doorvest

After you’ve matched with a property on the Doorvest platform, reach out to our Client Partner who will introduce you to a qualified 1031 intermediary (QI), also known as an exchange facilitator, to help coordinate the exchange of the subsequent real estate.

The 1031 intermediary (QI) will oversee the transfer of funds to ensure no income tax is required or hold the funds in escrow until your exchange is complete. They can also help you decide how much of your sale proceeds should go toward the new property.

Utilizing one of our partnered exchange facilitators, such as Accruit, will be helpful as they can walk you through the entire process, make sure you meet key deadlines, and ensure you appropriately defer any tax obligations.

Step 4 - Closing the Deal on Your Like-Kind Exchange

Doorvest will be your best point of contact to help walk you through the process of getting to the closing table. There are a few deadlines you will need to keep your eye on to ensure your gain on sale isn’t taxable.

The first deadline is to find a replacement property within 45 days from the date your property is sold, which can be proactively done even before your sale is complete (Forbes). This should be put in writing.

The second deadline is the acquisition date of the property you intend to purchase through the exchange. You must complete that purchase no later than 180 days after you sell your property or after your tax return is due (whichever is earlier)(Forbes).

All other special considerations aside, working with your exchange facilitator and meeting these key deadlines will get you to the closing table and ensure a smooth transaction.

Step 5 - Report Your Transaction to the IRS

It’s important to communicate with your exchange facilitator to make sure you file your taxes correctly and report your 1031 exchange correctly to the IRS after your deal closes. They will advise you to file an IRS form 8824 which describes the subject properties, how the exchange occurred, and the treatment of proceeds.

Other Considerations for 1031 Exchanges

With the help of an expert exchange facilitator, 1031 exchanges don’t have to be overly dense. Nevertheless, there are still some key factors you should consider when initiating this type of transaction.

For starters, if you can’t complete your like-kind sale within 180 days, then you can cancel the transaction but are then required to wait for a full 180-days to receive your net proceeds from your sold property (Forbes). It should also be understood that capital gains tax would then still apply (Forbes).

Another factor to consider is that if the value of your replacement property is less than the one you sold, the difference is called boot, which can be taxable by the IRS.

It's equally important to understand that like-kind exchanges allow you to defer your capital gains tax. Eventually, the taxes will be due, unless you keep deferring them with another 1031 exchange.

This can be a common strategy amongst real estate investors. If used correctly, there is no limit to how many 1031 exchanges can be completed by any given investor.

Keep in mind there are some restrictions if you try to occupy your swap property as a second home or primary residence. The IRS’s safe harbor rules would go into effect.

This means the replacement property could still qualify under the exchange rules provided it meets certain criteria. To begin with, during the subsequent two 12-month periods after the exchange the property must at some point be rented to another person for at least 14 fair market rental days (or more) (IRS).

The other stipulation is that your personal use of the dwelling cannot exceed 14 days or 10% of the number of days during the 12-month period the dwelling was rented (IRS).

Lastly, 1031 exchanges can be a great way to avoid depreciation recapture. Typically, when you sell an investment property and are claiming depreciation as a deduction on your tax returns, the IRS will want to recapture a portion of that taxable income.

A 1031 exchange can delay that recapture by rolling over your cost basis from the property you sold to your replacement property, almost as if you still owned that old piece of real estate.

Key Takeaways

Like-kind exchanges are a great tool to help save savvy real estate investors money by allowing you to defer capital gains taxes. While 1031 exchanges can be a bit complex, with the assistance of an expert exchange facilitator like Doorvest, the process can be both painless and lucrative. Just make sure to weigh all factors before deciding if a 1031 exchange is right for your real estate investment strategy.

At Doorvest, we help our customers acquire replacement property anywhere in our markets entirely online with the assistance of industry experts at Deferred.