Selling a rental property for a huge profit can feel like a major win…until you get the tax bill. Thankfully, with a 1031 exchange, you can defer the capital gains tax and reinvest more of your profits. What is a 1031 exchange, how does it work, and when should you do one? In this article, we’re breaking down this tax strategy, its pros and cons, and some of the rules you can’t afford to miss!
Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. 1031 exchange rules are complex and subject to change — consult a qualified tax advisor, CPA, or exchange accommodator before initiating any exchange. Timelines, property eligibility, and IRS requirements vary based on individual circumstances. Rent to Retirement does not provide tax or legal services.
Summary:
From Section 1031 of the IRS tax code, a 1031 exchange is a strategy that allows investors to sell a rental property and reinvest the proceeds in a “like-kind” asset. This defers the capital gains tax that is usually due upon sale of the property.
Note: A 1031 exchange does not eliminate your capital gains tax burden. It merely defers it. If you sell the “like-kind” asset without another 1031 exchange, you will be responsible for paying the capital gains tax and the depreciation recapture.
A “like-kind” asset is similar in nature to the asset you’re selling. If you’re selling an investment property, another investment property would be considered a “like-kind” property—not a primary residence, stock investment, or any other non-real estate-related asset.
Exchange your headache rental for a cash-flowing, managed turnkey rental!
There are a few reasons why investors prefer doing a 1031 exchange rather than selling properties normally:
When you do a 1031 exchange, you roll all of the proceeds from one property into the next. This allows you to not only defer capital gains taxes but also keep any profits in the portfolio!
When you sell a property, you’re thwarting some of your momentum by paying taxes on the profits. With a 1031 exchange, you’re putting 100% of the sale profits back into other investments, allowing them to compound faster!
If you’re selling a one-million-dollar home but no longer want your money tied up in a single asset, you could 1031 exchange into two or three turnkey rentals—newly built or renovated properties that are professionally managed and involve far fewer headaches than many other properties!
You can sell one property and move the proceeds into a more expensive house, increasing your leverage in real estate. For example, if you sell a paid-off $500,000 house and move all that money into a $1,000,000 home, you’ve got (roughly) a 50% loan-to-value (LTV) ratio.
You’re preparing to sell a property and want to use a 1031 exchange to defer capital gains tax. Follow these four simple steps:
When you sell your investment property, the proceeds must go to a qualified intermediary (QI), a neutral third party that receives and deploys the funds during the 1031 exchange process.
Once you sell your first property, you have 45 days to formally identify the next asset(s) you plan to buy.
Remember, you have 180 days from when you sell your property until you must close on the “like-kind” property!
If you buy a “like-kind” property (or properties) of greater value within the 180-day allowance, your capital gains taxes will be deferred!
Let’s say you have a “headache” rental property you bought for $300,000 that’s now worth $500,000, meaning you could net roughly $200,000 when you sell. The problem is, you’ll owe $30,000-$40,000 (15%-20%) in federal capital gains tax alone.
Instead, you identify two cash-flowing, $240,000 turnkey rentals with property management and tenants already in place (your $500,000 sale nets closer to $480,000 after typical selling costs). You choose your QI, sell your $500,000 property, and buy the two turnkey properties. Now you’ve successfully deferred upward of $30,000 in taxes, your profits are working harder for you today, and you’ve got two assets generating more semi-passive income!
The IRS has strict guidelines you must follow when doing a 1031 exchange. One misstep could trigger a hefty tax bill!
After selling your property, you have 45 days to formally identify a like-kind property you intend to purchase.
From when you sell your property, you have a maximum of 180 days to purchase the next property (or properties).
The value of the like-kind property (or properties) must exceed the value of the property you’re selling. If not, the leftover proceeds will be taxed.
There are also rules when identifying the assets you intend to buy. You must meet one of these requirements:
Many investors intend to defer capital gains tax until they pass away, a strategy known as “swap until you drop.” By triggering a 1031 exchange each time you sell a property, you can defer capital gains taxes indefinitely. When you pass, your heirs will inherit the properties with a “stepped-up basis,” meaning the assets are assessed at their current market value—erasing any capital gains on paper.
Browse cash-flowing turnkey rentals with projected returns!
Is a 1031 exchange the right option for you? Make sure you understand all of the benefits and drawbacks of this tax strategy!
Many investors use the 1031 exchange strategy because of the following:
Lets Your Money Compound Faster: Roll your profits into the next property without paying taxes on the first one.
Defers Capital Gains Taxes: Rather than losing thousands of dollars to taxes today, you can defer them for years (or even decades) from now!
Defers Depreciation Recapture: When you take depreciation deductions on a rental property, you’re lowering your tax basis. The IRS will want to recapture some of that benefit when you sell the property for a gain.
Can Be Done Indefinitely: “Swap ‘til you drop” is a real strategy! In theory, you could keep moving equity from one property into the next until you pass.
A 1031 isn’t always the right move. Here are a few disadvantages to keep in mind:
Quick Timeline: You’ve got to formally identify the next property within 45 days and close in 180 days!
Defers, Doesn’t Delete Taxes: A 1031 exchange pushes your taxes out into the future. It doesn’t get rid of them!
Limited to Like-Kind Properties: You can’t 1031 exchange into a primary residence, stocks, or another investment. It must be for a property that’s used for business or investment—like a rental property!
Must Reinvest All Profits: 100% of your net proceeds must go toward the like-kind property if you want to defer all capital gains tax. Any cash you pull out of the transaction is subject to tax and depreciation recapture.
A “reverse” 1031 exchange is a strategy some investors use to buy their replacement property before the first property sells, which can be useful when you find the right deal. Since the IRS doesn’t allow simultaneous ownership of both properties involved in a 1031 exchange, a third-party Exchange Accommodation Titleholder (EAT) temporarily holds title to one of the properties until both transactions are complete. The same 45- and 180-day deadlines apply, and “reverse” exchanges are much more complex (and costly) than normal 1031 exchanges, so working with an experienced QI and tax advisor is crucial!
Don’t want to fork over tens of thousands of dollars to the IRS when you sell your property? You can defer your capital gains taxes and keep more of your profits reinvested with a 1031 exchange. But rather than having your equity tied up in one property, Rent to Retirement can help you move it into multiple, cash-flowing turnkey properties that give you more semi-passive income!
You cannot use a 1031 exchange on a primary residence, a vacation home (if it’s mainly for personal use), or properties that are considered “inventory” (like a house you’re flipping).
Only properties used for business or as an investment are eligible for a 1031 exchange. When you 1031 exchange into the next property, it’s recommended that you rent it out for at least two years before moving into it.
There are a few downsides to doing a 1031 exchange. For one, you’re not actually eliminating capital gains taxes—just deferring them. A 1031 exchange also has a more complicated closing process with extra costs, and you lose some flexibility by locking up all of your equity in another property.