What Is a 1031 Exchange?

A 1031 exchange, also known as a like-kind exchange, allows investors and business owners to defer capital gains taxes when they sell one investment property or business property and purchase another. That includes federal capital gains taxes, which can be up to 20% in 2024, and depreciation recapture taxes, which are capped at 25% of the gains.

The 1031 exchange allows investors and business owners the opportunity to forget about tax liability when they want to diversify the type or location of the property they own. For example, if business owners want to sell their real estate in New York and invest in real estate for a new business in Florida, they can defer taxes and have more money to invest in their business by using the like-kind exchange strategy.

Many real estate owners use the 1031 exchange to exchange one property for another indefinitely, while deferring capital gains taxes.

But 1031 exchanges have some drawbacks. One downside is that you must continue to buy real estate rather than access the cash that would result from the sale of the exchanged property.

While this article summarizes the details of a 1031 exchange, you should also refer to IRS code as well as speak with a tax advisor before utilizing this option.

Also note that while most states recognize 1031 exchanges, some do not and laws can vary from state to state. It's important to speak with your tax advisor before utilizing a 1031 exchange.

 

How Does a 1031 Exchange Work?

A 1031 exchange works by allowing you to exchange the tax liability from selling one investment property for the commitment to reinvest in another property of equal or greater value. If you're seeking to defer taxes on the sale of an investment property, it's important to make sure you follow the proper protocol to comply with IRS rules.

High income earners may also pay an additional net investment income tax of 3.8%.

In order to defer all taxes with a 1031 exchange, the seller of the relinquished property must reinvest all of the cash proceeds from the sale by purchasing a replacement property of equal or greater value.

All real estate is exchangeable if it has been held as an investment property. That could include a building used for your business or a condo you've rented out for income.

Remember to talk to your tax advisors to ensure that your property qualifies for an exchange. For instance, if you rent out a vacation home, but your own family uses it more than two weeks each year, the IRS may not view it as an investment property.

A 1031 exchange is sometimes referred to as a like-kind exchange, which refers to an exchange involving a similarly priced or higher priced property. However, it doesn't have to be the same type of property. For example, an investor could sell a retail site and purchase a multifamily building using a 1031 exchange.

Can a 1031 Exchange be Used on a Primary Residence?

No, a 1031 exchange does not apply to a personal residence. The rule only applies to investment properties, and the IRS excludes any property that the owner or owner's family uses for more than two weeks during a year.

However, you can sell your primary home and avoid paying capital gains taxes for the first $250,000 of your profits as an individual, or the first $500,000 as a married couple, as long as you have lived in the home for at least two of the past five years.

Can Someone Live in a 1031 Exchange Property as a Primary Residence?

Yes, someone could move into a property that was purchased through a 1031 exchange. However, the IRS may investigate the intent of the purchase to confirm that the house was originally purchased as an investment property.

 

Benefits of Pursuing a 1031 Exchange

The primary benefit of a 1031 exchange is tax deferment. After selling an investment property, rather than paying about 30% of the profit in taxes, a 1031 exchange allows you to invest that 30% (along with the remaining 70%) in a new real estate investment. It's a valuable way to build your real estate portfolio, shift your investing focus if needed and grow wealth by deferring taxes.

 

Length of Time to Utilize 1031 Exchange

The clock starts ticking on your 1031 exchange as soon as you relinquish the title to the property you're selling. From that point, you have 45 calendar days to identify replacement properties. You can list three potential replacements or several replacement properties that total no more than 200% of the value of your relinquished property.

After the sale closing date, you have 180 calendar days to acquire one or more of the identified replacement properties—and you have the option of exchanging the proceeds from one property into multiple new assets.

The 45-day and 180-day countdowns start simultaneously on the closing day for the sale.

When your property exchange meets all the IRS requirements, you can defer indefinitely all taxes associated with the sale. And because a 1031 exchange is not a one-time-only option, investors can conduct them repeatedly to continue deferring capital gains taxes on property sales.

 

1031 Exchange in California

Some states, including California, have additional rules that apply to the standard federal 1031 exchange rule. For example, the following rules affect 1031 exchanges originating in the state of California.

If you'd like to utilize the 1031 exchange in California, keep reading and be sure to consult the State of California Franchise Tax Board's official page about the process.

Intermediaries Must Be Bonded

In California, any qualified intermediary that facilitates an exchange for a fee must meet one of the following criteria:

• Maintain a bond of $1 million or more
• Deposit $1 million in cash, securities or irrevocable letters of credit
• Deposit all exchange funds in a qualified escrow account.

Investors Must Meet Filing Requirements

If an investor performs a like-kind exchange of property in California for property outside the state and defers any gain or loss under IRS 1031, the investor must report that to the state using form FTB 3840.

The investor is required to file FTB 3840 every subsequent year, for as long as they defer the gain or loss, even if they exchange the out-of-state property for another out-of-state property with another 1031 exchange. The form must be filed every year until the investor pays tax to the state of California on that original gain or donates the property to a nonprofit organization.

California has a "claw back law" that states that any capital gains deferred from real estate in the state will be subject to California state tax upon the ultimate sale of the real estate, even if the owner has used a 1031 exchange to acquire a property outside the state.

 

Working with a Qualified Intermediary (QI)

As a safe harbor, the IRS requires taxpayers to work with a qualified intermediary (QI), such as City National Bank, to protect their interests throughout the process of a 1031 exchange.

These professionals set up structures to securely hold funds from the sale of an investment property until they can be used for the purchase of a new property. Your own attorney, accountant, realtor or another family member is not allowed to do this for you.

When seeking a QI, pay attention to security and transparency: In recent years, several QIs have operated Ponzi schemes, using the funds from clients' property sales to fund their own lifestyles.