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1031 Exchange Guide: Defer Taxes When Selling Investment Property
Sold an investment property for a profit? A 1031 exchange lets you defer capital gains taxes by reinvesting in another property. Here's how it works.
What Is a 1031 Exchange?
Named after Section 1031 of the IRS tax code, this provision allows you to defer capital gains taxes when you sell an investment property—as long as you reinvest the proceeds in a "like-kind" property.
Key word: Defer. You're not avoiding taxes forever. You're postponing them until you eventually sell without exchanging.
The Tax Savings
Without a 1031 exchange, you'd pay:
- Federal capital gains: 15-20%
- State capital gains: 0-13%+ (varies by state)
- Depreciation recapture: 25%
- Net Investment Income Tax: 3.8% (high earners)
Example:
- Purchase price: $200,000
- Sale price: $400,000
- Gain: $200,000
- Depreciation taken: $50,000
Without 1031:
- Capital gains tax (20%): $40,000
- Depreciation recapture (25%): $12,500
- NIIT (3.8%): $7,600
- State tax (5%): $10,000
- Total tax: $70,100
With 1031: $0 (deferred)
Requirements for a Valid 1031 Exchange
1. Like-Kind Property
Both properties must be:
- Investment or business use (not personal residence)
- Real property (land or buildings)
- Located in the US (for US property)
"Like-kind" is broad. You can exchange:
- Single-family for multi-family ✓
- Rental home for commercial building ✓
- Raw land for apartment complex ✓
- Residential for industrial ✓
2. Qualified Intermediary (QI)
You cannot touch the proceeds. A third-party QI must:
- Hold the sale proceeds
- Transfer funds to buy replacement property
- Handle documentation
Cost: $500-1,500 typical
3. Strict Timelines
- 45 days: Identify replacement property(ies)
- 180 days: Close on replacement property
These deadlines are absolute. No extensions.
4. Equal or Greater Value
To defer ALL taxes, the replacement property must be:
- Equal or greater in price than what you sold
- Equal or greater debt (or add cash)
If you buy less, you'll pay tax on the difference ("boot").
The 1031 Exchange Timeline
Day 0: Close on sale of relinquished property. Proceeds go to QI.
Days 1-45: Identify up to 3 replacement properties (or more under special rules). Must be in writing to QI.
Days 46-180: Close on one of your identified properties. QI transfers funds to complete purchase.
Day 181+: If you haven't closed, the exchange fails. Proceeds are returned and taxes are due.
Identification Rules
You can identify replacement properties using:
3-Property Rule
Identify up to 3 properties of any value.
200% Rule
Identify unlimited properties, but total value can't exceed 200% of relinquished property.
95% Rule
Identify unlimited properties if you acquire 95%+ of their total value.
Most investors use the 3-property rule for simplicity.
Common 1031 Mistakes
1. Missing Deadlines
45 and 180 days are firm. Mark your calendar.
2. Touching the Money
If proceeds come to you (even briefly), the exchange is invalid.
3. Same Taxpayer Requirement
The same entity that sells must buy. Can't sell from LLC and buy personally.
4. Using for Personal Property
Primary residences and vacation homes don't qualify (with limited exceptions).
5. Insufficient Identification
"The property on Main Street" isn't valid. Use addresses and legal descriptions.
Types of 1031 Exchanges
Delayed Exchange
Most common. Sell first, then buy within 180 days.
Reverse Exchange
Buy first, then sell. More complex and expensive. Requires "Exchange Accommodation Titleholder."
Build-to-Suit Exchange
Use proceeds to build or improve replacement property. Must complete within 180 days.
Drop and Swap
Add or remove partners before/after exchange. Complex planning required.
1031 Exchange Costs
| Item | Typical Cost |
|---|---|
| Qualified Intermediary | $500-1,500 |
| Legal review | $500-2,000 |
| Title & closing | Standard costs |
| Rush fees (if needed) | $500+ |
Total exchange costs: Usually $1,000-3,000
Still far less than the taxes you'd pay without it.
When NOT to Do a 1031 Exchange
Consider paying the tax instead if:
- You want to access equity (can't pull cash in 1031)
- You're in a low tax bracket this year
- You can't find suitable replacement property
- You're retiring from real estate investing
- The replacement property doesn't make investment sense
1031 + HELOC Strategy
Some investors use HELOCs strategically with 1031 exchanges:
Scenario: You need some cash but want to defer taxes.
- Complete 1031 exchange into new property
- After exchange closes, get HELOC on new property
- Access equity tax-free through HELOC
- Taxes remain deferred
This provides liquidity while maintaining tax deferral.
Finding Replacement Properties
The 45-day identification deadline is tight. Start looking BEFORE you sell:
- Work with investment-focused agents
- Set up property alerts
- Consider multiple markets
- Have backup properties identified
- Look at DSTs (Delaware Statutory Trusts) as backup
The Bottom Line
1031 exchanges are one of the most powerful tax strategies for real estate investors. With proper planning and strict adherence to rules, you can:
- Defer hundreds of thousands in taxes
- Trade up to larger properties
- Diversify across markets
- Keep more capital working for you
Next Steps
- Consult a tax professional before selling
- Line up a Qualified Intermediary early
- Start property shopping before your sale closes
- Document everything meticulously
Related Resources
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