1031 Exchange Explained: Everything You Need to Know

Ah, the 1031 exchange—perhaps the most money-savvy way to defer capital gains taxes while building your long-term wealth.

1031 exchanges can help you swap an investment property for another and defer capital gains taxes—but they aren't quite straightforward. In fact, they're downright complicated, and they're riddled with nitty-gritty rules that could make or break your investment.

Get your 1031 exchange right, and you could avoid some hefty taxes while building your investment portfolio. Get it wrong, and you might have to eat a chunky tax bill.

Considering a 1031 exchange? Or just curious and want to learn more? Regardless, you've come to the right place. 

Below, we'll break down everything you need to know about 1031 exchanges:

• What Is a 1031 Exchange?

• How Does a 1031 Exchange Work?

• Benefits of Doing a 1031 Exchange

• What Makes a 1031 Exchange So Downright Difficult?

• Let Nomad Help With Your 1031 Exchange

What Is a 1031 Exchange?

A 1031 exchange (also known as a like-kind exchange or Starker exchange) lets you swap one investment property for another. Without a 1031 exchange, you'd have to pay taxes on the sale of your former property—but if your trade meets the requirements of Internal Revenue Code (IRC) Section 1031, you won't face any tax implications at the time of the swap.

A 1031 exchange simply lets you change the form of your investment. Since you're just swapping out your investment, the IRS doesn't recognize it as a cash out or capital gain.

Without a 1031 exchange, you’d likely make a capital gain from the sale of your property, and that gain would be subject to IRS taxes. However, you still have to pay realtor commission, inspection fees, attorney fees, insurance, intermediary fees, and the like when you sell your property—and those can decrease the income you make from the sale, lowering your capital gains portion.

Note that a 1031 exchange isn't a tax-free way to invest in real estate—it's tax-deferred. You'll eventually have to pay taxes if you sell a piece of real estate for a lump sum of cash. However, as long as you keep swapping your property for like-kind assets, you can keep deferring your tax payment.

The IRS's definition of "like-kind exchange" isn’t as strict as you might think. You don't need to trade a single-family property for another single-family property or an apartment building for an apartment building. You could trade a strip mall for a ranch or raw land for a multifamily property.

How Does a 1031 Exchange Work?

1031 exchanges can be complex. That's why we always recommend working with a qualified professional to ensure you do it right. 

However, at a high level, here are the steps you can expect:

• Identify the Right Property Sell: Properties used as your primary residence or vacation home likely won't qualify for a 1031 exchange. You typically can only use this tax-deferment strategy for investment properties, such as a home that you're renting out.

• Find a Like-Kind Property to Buy: The property you're buying needs to have a similar nature and characteristics to the one you're selling. Plus, you have to get the timing of your purchase and sale right to qualify for a 1031. Also, you can't use a 1031 exchange to sell a property in the US and purchase one across borders.

• Choose an Intermediary: An intermediary will receive the cash from the sale of your investment property and use it to purchase your like-kind property. By keeping your funds in a secure escrow until the exchange is complete, you avoid receiving the money personally and making a capital gain. You don't have to use all the sale proceeds towards your next property—however, you'll have to pay capital gains tax now on any portion you keep.

• Inform the IRS: File IRS Form 8824 with your tax return. This form describes the transaction, properties, timeline, and other details of your 1031 exchange to ensure the IRS doesn't come asking for money.

And that's that.

Now, this is an over-simplified explanation of how a 1031 exchange works. There are lots of moving parts, nuances, and special rules that make each step a bit trickier.

Again, we recommend working with 1031 exchange experts. They know the ins and outs of this process, and they can help you avoid costly slip-ups. Nomad specializes in 1031 exchanges. We’ve been there, done that—and we can help you do the same for your investment properties.

Benefits of Doing a 1031 Exchange

While 1031 exchanges can be notoriously difficult, their advantages far outweigh the hassles. Here are just a few of the noteworthy benefits of a 1031 exchange:

• Tax Deferment: Defer paying taxes and keep growing your long-term wealth.

• Investment: Swap your investment for a more promising property or real estate in a hotter market. You can also upgrade your investment—for example, you might trade a single-family apartment for a multifamily unit or swap raw land for an apartment complex.

• Depreciation Reset: Reset the depreciable amount of your investment property to yield bigger tax benefits.

• Liquidity: Trade your property for a more liquid asset that will allow you more flexibility. For example, you might swap your property for a more in-demand type of home or for property in an up-and-coming market.

• Estate Planning: Tax liabilities end with death. If you die without selling the property you've obtained through a 1031 exchange, your heirs won't have to pay the deferred taxes. Instead, they'll inherit the property at its stepped-up value.

What Makes a 1031 Exchange So Downright Difficult?

1031 exchanges aren't all lollipops and giggles, though—they can be super hard to navigate and execute correctly. However, that doesn't mean you should avoid them. 

You just need to know what you're getting into:

1. Not Always Obvious When to Do a 1031 Exchange

You may be in the perfect situation to do a 1031 exchange and just not realize it. Or you might be able to position your property for a 1031 exchange with a bit of upfront know-how and investment. 

In fact, many accidental landlords—those that rent out their primary home after they’ve lived in it—are the perfect candidate. It’s common to own a sub-optimal investment property when you could have a perfect one.

For example, if you just inherited a property, a 1031 exchange might be better for your investment portfolio than cashing out or renting it.

There's also the 2-out-of-5-year rule. This rule states that you can exclude up to $250,000 from gains of a sale of your property ($500,000 on a joint return) if you've lived in the home for at least 24 months in the last 5 years—and those months don't have to be consecutive either.

You might not even need to consider a 1031 exchange if you qualify under that rule.

2. Difficult to Find Suitable Properties

Finding a like-kind property is easier said than done, especially right when you need it. The IRS's rules narrow down which properties qualify, and you could find yourself in a bit of a pickle if you can't find a suitable property within 45 days of selling your property.

Here's what you'll need to keep in mind when looking for a like-kind property:

• The replacement property must be in the US

• It needs to be of the "same nature or character" as the property you sell

• The nature and character primarily refer to real property, as opposed to trading a rental unit for stock or bonds. Nature and character also have nothing to do with grade or quality. That means a broken-down apartment building can be traded for an upgraded one.

• The property must be "held for productive use in a trade for business or for investment"

• This means you can’t purchase a property with the primary intent to sell, such as purchasing a fixer upper or vacant land to build a home. You also can’t use a 1031 exchange to purchase a property you plan to use as a primary residence.

• The property's market value must be greater than or equal to the property you sell

• Also, a buyer must replace their previous mortgage with a mortgage of equal or greater value to avoid realizing a capital gain.

3. Property Values Might Seem High Right Now

With property values reaching all-time high prices, it might seem dangerous to trade your investment property. You might not get your money's worth, and you might take on additional debt to afford the new property's "greater than or equal to" value.

4. Nailing the Time of the Exchange Can Be Challenging

There are a few deadlines you need to keep in mind when executing a 1031 exchange:

• 45-Day Rule: You must identify and designate your replacement property (in writing) to the intermediary within 45 days of the sale of your property. If you haven't narrowed down your choices yet, you can choose up to 3 properties—but you'll have to close on at least 1 of them to avoid spoiling your 1031 exchange.

• 180-Day Rule: You must close (not just get your offer accepted) on your replacement property within 180 days of the sale of your previous property. 

In an ideal world, you'd always be able to find the right property in this timeframe—but that's not always the case.

You can also execute a reverse exchange and still reap the benefits of a 1031. With a reverse exchange, you buy the replacement property before selling the previous one. However, the 45-day and 180-day rules still apply—you just need to identify and close on the sale of your property in this timeframe.

5. Hard to Get Financing

1031 exchanges can be tricky to finance. For example, many banks won't provide loans for reverse exchanges, which means you'll need the money for an all-cash deal—which is hard to come by when purchasing an investment property.

6. Competitive Market Conditions

Competitive market conditions make it difficult to sell your home, identify a new property, and close on the deal within the IRS' established deadlines. Homes are selling at record pace—the average length a property stayed on the market was just 18 days earlier this year.

With properties flying off the shelves (so to speak), it can be challenging to secure a like-kind property—especially when you have to coordinate the sale of your property, too.

7. Entire Process Can Feel Complicated and Overwhelming

Just reading through all these rules probably makes you feel a little over your head. It's a lot to soak in, and it can be difficult to remember all the rules and nuances. Selling or renting your investment property can feel like a more straightforward option, even if they're not the best strategies for growing your wealth or satisfying your financial goals.

Let Nomad Help With Your 1031 Exchange

Feeling overwhelmed? Don't be. Nomad can help.

We specialize in 1031 exchanges to help you tax-efficiently maximize your assets. Our experts can help you find the perfect like-kind replacement property before you sell your property—we even have access to off-market inventory to ensure you have a great replacement property lined up in advance. 

You don't have to do this alone. And if you haven't done a 1031 exchange before, you shouldn't.

Not sure if a 1031 exchange is right for you? You have other alternatives, too. Check out the top 3 options when deciding what to do with your property.