What You Need to Know About a 1031 Exchange

If you invest in real estate, you should understand the 1031 exchange tax strategy. Named for Section 1031 of the Internal Revenue Code, this strategy lets you defer capital gains tax when you swap one investment property for another. First, it can free up cash for bigger deals. Next, it can compound your real estate wealth over decades. However, the rules are strict and the deadlines unforgiving, so keep reading to learn what you need to know.

What Is a 1031 Exchange?

In simple terms, a 1031 exchange is a legitimate tax move that lets real estate investors swap one investment property for another without paying capital gains tax at the time of sale. The 1031 exchange tax strategy is especially useful when you want to upgrade your real estate holdings without triggering a tax bill on the transaction.

Three keys make a 1031 exchange work:

• The proceeds from the sale must never touch your hands. A neutral third party holds the funds in escrow until the transaction closes.
• Two strict, simultaneous timelines apply: one for identifying a replacement property in writing, and one for closing on the new property.
• The rules are complex. As a result, you should work with a qualified intermediary and a CPA who handles real estate exchanges.

Important update for tax years 2018 and later: The Tax Cuts and Jobs Act limited Section 1031 to real property only. Equipment, vehicles, artwork, and other personal property no longer qualify. The IRS confirms this in Publication 544.

What Are the Rules for a 1031 Exchange?

The IRS sets specific rules for any real estate investor using the 1031 exchange tax strategy. The three biggest ones cover like-kind property, timing, and qualified intermediaries.

Rule 1: The Exchange Must Involve Like-Kind Real Property

According to the IRS guidance on like-kind exchanges, like-kind properties are two real estate assets of a similar nature, regardless of grade or quality. The property must be held for business, trade, or investment use. Personal residences do not qualify.

For example, here are several pairings that meet the like-kind test:

• A condominium for a hotel
• Vacant land for a retail property
• An apartment building for an industrial building
• A shopping complex for a medical office
• A parking lot for a vacant school building

As you can see, the like-kind definition focuses less on the similarity of the buildings and more on the purpose of ownership: investment or business use.

Rule 2: You Must Meet Two Strict Deadlines

The 45-Day Rule covers the identification step. Within 45 days of selling your original property, you must identify the replacement property in writing. You may designate up to three potential replacements, and more if you meet specific valuation tests, as long as you ultimately close on one of them.

Next comes the 180-Day Rule for closing. You must close on the replacement property within 180 days of selling the old property. Miss either deadline and the exchange fails, which means you owe capital gains tax on the original sale.

Rule 3: You Must Use a Qualified Intermediary

A qualified intermediary, sometimes called an exchange facilitator, holds the funds in escrow throughout the transaction. Using one is not optional. If the money enters your account at any point, the IRS treats the deal as a taxable sale.

The intermediary sells the old property on your behalf, buys the replacement property, and routes the funds between the two closings. Choose carefully. Your intermediary cannot be a relative, attorney, banker, employee, accountant, or real estate agent who has worked for you in the past two years. You must use a fully independent third party.

Frequently Asked Questions About the 1031 Exchange Tax Strategy

Now that you know how a 1031 exchange works, here are the questions we hear most often from childcare owners and other real estate investors.

When would I consider using a 1031 exchange?

A 1031 exchange may make sense in several situations. For example, you may want to trade up to a property with better cash flow, consolidate several smaller properties into one for estate planning, or convert an underused vacation home into a rental and later swap it for a larger investment property. In each case, the 1031 exchange tax strategy lets you reinvest the full sale proceeds instead of handing a slice to the IRS.

What steps are involved in a 1031 exchange?

The process follows six steps:

• Step 1 — Identify the property you want to sell.
• Step 2 — Identify the property you want to buy.
• Step 3 — Choose a qualified intermediary.
• Step 4 — Decide how much of the proceeds to reinvest.
• Step 5 — Hit the 45-Day and 180-Day deadlines.
• Step 6 — Report the exchange to the IRS on Form 8824 with your tax return.

What happens to the capital gains tax?

In a 1031 exchange, capital gains tax is deferred, not erased. You will not owe it in the year you complete the swap. However, you will owe it when you eventually sell the replacement property for cash. Meanwhile, if you keep “1031-ing” each property into the next, you can defer the tax indefinitely.

How does this build long-term wealth?

Continually deferring capital gains tax on each new property keeps your full equity working in the market. As a result, you can reinvest the tax-deferred funds into larger or higher-yielding real estate. Investopedia notes that a well-run chain of exchanges can compound returns significantly over a career. Finally, if you die owning property you obtained through 1031 exchanges, your heirs receive a stepped-up basis at fair market value, and the deferred tax debt is wiped out.

Who can help me with my 1031 exchange?

A 1031 exchange is a complicated process with no second chances on the deadlines. For that reason, we always recommend working with a CPA and a qualified intermediary before you list the property. If you would like financial guidance on a 1031 exchange tax strategy, reach out to our team.

Make the 1031 Exchange Tax Strategy Work for You

Real estate can be one of the most powerful long-term wealth builders for a childcare owner or any small-business owner. The 1031 exchange tax strategy is one of the strongest tools the tax code offers to keep that wealth compounding. Plan early, line up the right team, and respect the deadlines.

For more tax-saving ideas, take a look at our posts on the Augusta Rule and important KPIs to track for your ECE business. If you are also juggling rental property alongside a daycare, our guide on encouraging timely pick-ups from parents can help free up the headspace for bigger-picture moves like this one.

Honest Buck Accounting exists to help Early Childhood Education businesses and the owners who run them build a strong financial foundation. Our experts offer accounting, tax, and advisory services that streamline your finances and increase profitability. Contact us today.