Understanding the Tax Advantages of a 1031 Exchange

1031 exchanges have been around for nearly 100 years. They are a tax deferral strategy used by successful commercial real estate investors to generate more capital for future investment in real estate, such as rental property for sale and multi-unit property for sale. 

In this article, we’ll look at the tax advantages of a 1031 exchange, explain how a tax-deferred exchange works, and answer some commonly asked questions.

What is a 1031 Exchange?

Section 1031 of the Internal Revenue Code allows real estate investors to defer paying capital gains tax when an investment property is sold, provided that a like-kind replacement property of equal or greater value is purchased within certain time limits.

A 1031 exchange may also be known in some real estate markets as a Starker Exchange, a Tax-Deferred Exchange, a Like-Kind Exchange, or simply a 1031.

Example of How a 1031 Tax-Deferred Exchange Works

Here’s a simplified, hypothetical example of how a 1031 tax-deferred exchange works, with certain assumptions made regarding factors such as depreciation and tax liability. Remember, if you’re thinking about 1031 exchange properties, be sure to ask a financial advisor or 1031 exchange facilitator about your specific situation. 

1. The property being relinquished

Several years ago, you purchased a shopping center for $1,350,000, with a down payment of $350,000 and mortgage financing of $1,000,000. 

2. Adjusted tax basis calculation

Your shopping center’s adjusted tax basis is currently $900,000 after accounting for capital improvements and depreciation deduction.

3. Realized gain

Retail in the market has performed exceptionally well despite the recession, and your shopping center has a current fair market value of $2,000,000. The analyzed realized gain is:

• Sale price = $2,000,000
• Minus closing costs = $150,000
• Equal net selling price = $1,850,000
• Minus adjusted tax basis = $900,000
• Realized gain = $950,000

4. Net cash received

The current mortgage balance of $800,000 must be paid off when the property is sold, leaving net cash received of:

• Sale price = $2,000,000
• Minus closing costs = $150,000
• Minus mortgage balance = $800,000
• Net cash received at time of sale = $1,050,000

Note that the amount of realized gain is different from the amount of cash received. We’ll use those two numbers in the final two steps.

5. Potential tax liability pre-1031 exchange

The shopping center is held in a limited liability company (LLC) with any profits or losses passed through to the individual taxpayer. For the purposes of this example, we’re making assumptions regarding the federal tax bracket and ignoring any state capital gains tax:

• Realized gain = $950,000
• Federal capital gains tax = $190,000 
• Depreciation recapture tax = $45,000
• Potential tax liability = $235,000

6. Use a 1031 exchange to defer capital gains

Finally, let’s take a look at the net cash you would have available to reinvest by conducting a 1031 tax-deferred exchange:

Without a 1031 exchange

• Net cash received from sale = $1,050,000
• Tax liability = $235,000
• Cash available to reinvest = $815,000

With a 1031 exchange

• Net cash received from sale = $1,050,000
• Tax liability = $0
• Cash available to reinvest = $1,050,000

By conducting a 1031 tax-deferred exchange, you would keep an additional $235,000 to reinvest in a replacement investment property by deferring the payment of capital gains and depreciation recapture taxes.

7 Basic Rules of a Section 1031 Exchange

There are seven general rules to follow regarding a Section 1031 exchange and 1031 exchange properties for sale:

1. Relinquished (sold) property title must be in the same name as the replacement (purchased) property, such as the same individual, partnership, or LLC.
2. Real estate must be held for investment purposes, not as a primary residence or property for personal use.
3. Property must be “like-kind” real estate, but can differ in type or quality, such as a shopping center replaced with multifamily homes for exchange.
4. Replacement real estate must be of equal or greater value to the property relinquished, including total sales price and replacement of an equal or greater mortgage if applicable.
5. Investors conducting the 1031 exchange must not receive boot: the money or the fair market value of “other property” received by the taxpayer, which occurs when the replacement property value is less than the relinquished property value.
6. Investors must identify replacement property within 45 days of closing on the sale of the relinquished property.
7. Purchase of the replacement property must occur within 180 days of closing on the relinquished property sale.

FAQs About a 1031 Exchange

Q: Do I have to exchange my property with someone selling a 1031 exchange property?

No, you cannot sell your relinquished property to anyone you wish to and buy a replacement property from any seller you want.

Q: Do the relinquished and replacement properties have to exchange simultaneously?

Conducting a 1031 exchange is not the same thing as a back-to-back close of escrow. You are allowed 45 days to identify one or more replacement properties and 180 days from the day your relinquished property sells to close on the sale of your replacement property.

Q: Does the replacement property have to be the same asset class as the relinquished property?

You can exchange from one asset class to another, provided the real estate is used for like-kind investment purposes. Examples of like-kind 1031 exchanges include selling a shopping center and buying a multifamily building or selling raw land for development and buying an office building.

Q: Is a 1031 exchange limited to one-to-one exchange?

No, you can relinquish a single property and purchase multiple replacement properties, or vice versa. For example, you could sell a single-family rental home portfolio and purchase a single large industrial distribution building.

Will the 1031 Exchange be Eliminated?

Being a real estate developer himself, President Trump advocated tax breaks for real estate investors. Although it’s too soon to tell, some sources anticipate President Biden scaling back or eliminating the tax benefits of a 1031 exchange and raising capital gains taxes on high-income earners.

If this occurs, commercial real estate investors may try to sell quickly before the 1031 benefits are taken away. This could also present a potential opportunity for buy-and-hold investors looking for motivated sellers of office, retail, industrial, and multifamily properties.

A 1031 exchange allows business owners and real estate investors to save money by deferring taxes on investment real estate sales. By conducting a 1031 exchange, taxpayers can have more capital to invest, generate more cash flow from income-producing properties, and rebalance and grow commercial real estate portfolios.