Real Estate: 1031 Exchange Examples

When investors want to diversify their portfolios, they often consider real estate. But if you’re interested in real property, you need to know the ins and outs of purchasing and selling. One method many investors rely on is called a 1031 exchange. By following the rules for this type of exchange, investors can defer their capital gains tax while working towards better and bigger properties. Understanding how a 1031 exchange works is crucial to its success, though. Here are a few example scenarios to help you get familiar with it.

Taxes and real estate can get confusing. Consider working with a financial advisor as you work to make sure your real estate investing is as tax efficient as possible.

What Is a 1031 Exchange?

A 1031 exchange is a tax-deferment strategy often used by real estate investors. In this process, the owner of an investment property (or multiple) sells their original property and buys a like-kind property as a replacement. By following the IRS’s rules during this procedure, they defer capital gains tax.

A like-kind property exchange doesn’t mean you need to swap the exact same type of building. They also don’t need to share the same quality, only their character or class. For instance, a vacant lot is like-kind with a real property improved with a rental building. You can tailor your exchange to meet your goals and needs as long as it meets the requirements laid out in Section 1031. However, investors should note that real estate within the U.S. cannot be like-kind with any property outside the country.

The process also requires the use of certain channels. Namely, you need an exchange facilitator. According to the IRS, this is a “qualified intermediary, transferee, escrow holder, trustee or other person that holds exchange funds for you in a deferred exchange” under the applicable terms.

There are also four different types of 1031 exchanges: simultaneous exchange, delayed 1031 exchange, reverse exchange and improvement exchange.

1031 Exchange Examples

A 1031 exchange requires you to fulfill two crucial rules.

First, there is a minimum value requirement. The new property, or properties, must have a purchase price equal to or more than the amount you sold your real estate for. So, if you sell your property for $600,000, then you must buy a replacement property worth at least that much.

The second requirement applies to financing. Essentially, anyone with a loan on their original property must carry the same amount of debt or more with the replacement property.

Here are some examples to illustrate how a 1031 exchange works.

Example 1: The Basics

Suppose you are a real estate investor. You choose to sell your current property with a $150,000 mortgage on it. It sells for $650,000. If you want to meet the conditions for a 1031 exchange, you much purchase a replacement property for at least $650,000. In addition, you need to borrow a minimum of $150,000 to pay for it.

Sounds straightforward, right? But we all know the real world is a little more complicated than this. The following examples show you how the situation may change.

Example 2: Higher Value Replacement

It’s unlikely you’ll find a replacement selling for exactly the same amount as your original property. With that in mind, let’s say you sell your property with a $300,000 mortgage on it for $500,000.

While searching for a replacement, you find a property you want to buy. But it’s valued at $700,000. In that case, you contribute $200,000 out of pocket and purchase the replacement with a $300,000 loan and $400,000 of cash. Like this, you can still defer taxes since you satisfy the two basic requirements.

Example 3: Increased Leverage

One concept in real estate is known as leveraging. Basically, it means using debt, such as a loan, to buy an asset, like property. Investors can increase their leverage using a 1031 exchange, allowing them to invest in a higher-value property. As a result, they can not only improve their cash flow but multiply the rate they build equity at.

So, suppose you sell one of your first investment properties for $500,000. You still owed $100,000 on the mortgage at the moment of sale. But you want to set your sights higher. As a result, you move to purchase a property that costs $1 million.

You use the total profit from the sale at $400,000 and take out a new loan worth $600,000. With this, you meet the 1031 exchange requirements.

Example 4: Partial 1031 Exchange

It’s actually possible to sell an investment property and satisfy the 1031 exchange rules without using all of your sale proceeds. This is called a partial exchange. However, buying a replacement for a lower cost than the original property’s sale price or taking out less financing will result in taxes.

For instance, we’ll say you sell your original property for $650,000. It had a $200,000 mortgage leftover. You then purchase a property for $500,000 but still take out $200,000 for the loan. The $150,000 in profit unused becomes taxable income.

Essentially, you still defer taxes on the better part of the sale from the first property. But the money that you didn’t put into the replacement still faces capital gains tax or depreciation recapture.

1031 Exchange Timeline: Understanding the 45-Day and 180-Day Rules

A delayed 1031 exchange must generally meet two important deadlines: the 45-day identification period and the 180-day exchange period. Both periods begin on the date you transfer the property you’re giving up, known as the relinquished property. Missing either deadline can cause the transaction to lose its tax-deferred treatment, so investors should understand the timeline before beginning an exchange.

Under the 45-day rule, you generally have 45 calendar days after transferring the relinquished property to identify one or more potential replacement properties. The identification must be made in writing, clearly describe the replacement property and be delivered to an eligible person involved in the exchange, such as the qualified intermediary. Weekends and holidays don’t extend the 45-day deadline.

The 180-day rule generally gives you 180 calendar days from the transfer of the relinquished property to receive the replacement property. Importantly, the 180-day period begins at the same time as the 45-day period; it does not begin after the identification period ends. The deadline can also be earlier if your federal income tax return is due before the end of the 180-day period, although filing an extension may provide additional time.

Example: Applying the 45-Day and 180-Day Rules

Suppose an investor sells an investment property on June 1 as part of a delayed 1031 exchange. The transfer starts both the 45-day identification period and the 180-day exchange period.

The investor generally has 45 calendar days to formally identify potential replacement properties. Once that deadline passes, they can’t simply substitute a different property that wasn’t properly identified. They must then acquire a qualifying identified replacement property before the applicable 180-day deadline.

The two deadlines overlap, so identifying a property on the final day of the 45-day period doesn’t give the investor another 180 days to close. At that point, roughly 135 days of the original 180-day exchange period would remain. Planning ahead can therefore be important, particularly when financing, inspections or other issues could delay the purchase of the replacement property.

Bottom Line

A 1031 exchange can allow qualifying real estate investors to defer capital gains taxes when they exchange investment or business real estate for other qualifying like-kind property. However, completing an exchange requires careful attention to IRS rules, including the 45-day identification period, 180-day exchange period and requirements governing how the sale proceeds are handled. Investors may also recognize some taxable gain if they receive cash or other non-like-kind property as part of the transaction. Because a 1031 exchange generally defers taxes rather than eliminates them, it’s important to consider both the immediate tax benefits and the long-term implications before proceeding.

A financial advisor can help guide you through the rules and consequences which could impact your future investments.

Tips for Investing

Many investors use real estate, whether through REITs or physical property, to diversify their portfolios. However, you may want guidance before you change your investing strategy. If so, consider speaking with a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
You may already be making strides to reach your retirement savings goals, complete with a strategized investment portfolio. Perhaps you even have an emergency fund safety cushion prepared for sudden changes. But maybe it’s time to diversify, earn greater returns or a passive income. In that case, real estate might be your golden ticket. Just research the historical trends and expected performance beforehand.
Most advisors recommend having a diversified portfolio. Adding real estate can offer additional diversification and non-correlated assets to your portfolio. Our asset allocation calculator can help you determine how much of your portfolio to invest in real estate.