What Are 1031 Exchanges and How Do They Work

As the real estate market continues to show strength, many investors have seen their investment properties dramatically increase in value. This has led to growing interest in 1031 exchanges. But what exactly is a 1031 exchange, who would benefit from one, and what are the rules and implications for executing one? We'll cover everything in this blog post.

What Is a 1031 Exchange

A 1031 exchange, named after Internal Revenue Code Section 1031, is a tax strategy that allows investors to swap investment properties. At its core, it lets you defer capital gains taxes by selling one investment property and reinvesting the proceeds into another "like-kind" property.

This strategy is particularly valuable for investors with properties they've held long-term. It allows them to postpone their tax burden while creating opportunities to diversify their real estate portfolio.

How Does a 1031 Exchange Work

In practice, a 1031 exchange can get quite complicated. There are three main steps or deadlines that must be adhered to in order to remain in compliance:

1. Using a Qualified Intermediary:
A third party—known as a qualified intermediary—must be used to handle the proceeds from the sale. This intermediary ensures you never take possession or control over the cash from your sold property. This step is critical because taking control of any portion of the cash proceeds can make them taxable.

2. Identification Period:
From the closing date on the sold property, you have 45 days to identify potential replacement properties.

3. Exchange Period:
The purchase of the replacement property must occur within 180 days of selling the original property. (Note that these timelines run concurrently—the 180-day period begins on the same day as the 45-day identification period, not after it.)

When purchasing the replacement property, its value should be equal to or greater than the sale price of the original property to ensure the entire capital gain is deferred. If you retain any cash from the sale (known as “boot”), that portion becomes taxable. Any boot is taxed at your applicable capital gains tax rate.

What Special Rules or Regulations Are There

First, let’s define “like-kind” properties. The definition here is relatively loose: the properties exchanged must share the same nature or character. For example, you could exchange an office building for an apartment complex. The main stipulation is that both properties are held for business or investment purposes—not as a personal residence.

This leads to a common question among those with multiple homes: Can I 1031 exchange my vacation house? The answer (like most things) is, it depends. If you and your family are the only ones using the vacation home, then it would not qualify. However, if you rent out the property for the majority of the year, it may qualify as an investment property.

Guidelines state that to qualify, you cannot use the property for more than the greater of 14 days or 10% of the total days it is rented out. For example, if you rent out your ski cabin for 200 days per year and only use it for 10 days per year, it would likely qualify. Keep in mind that the IRS scrutinizes these “mixed-use” properties, so maintaining proper documentation, rental records, and consulting with your tax and financial advisor are important.

Two final points are important: 1031 exchanges can only be executed with U.S. properties, and there is technically no limit on the number of times you can execute a 1031 exchange.

What Is a Delaware Statutory Trust and How Does It Relate to 1031 Exchanges

A Delaware Statutory Trust (DST) is a legal entity governed by Delaware law that allows investors to hold fractional interests in one or more properties. When paired with a 1031 exchange, a DST becomes an attractive replacement property option because it both diversifies your investment into multiple like-kind properties and defers capital gains taxes.

DSTs typically come with pre-packaged investments that are professionally managed and have already undergone due diligence. This offers a passive ownership approach, which is ideal if you no longer want the hassle of being a direct landlord. They also allow you to diversify across property types (e.g., apartment complexes and office space) and geographic areas—an option that might require significantly more capital if done on your own.

Of course, there are downsides to using a DST. Illiquidity is often the biggest downside, as a DST requires a long-term commitment—often five or more years. Additionally, while the passive nature of DSTs means you avoid management responsibilities, the sponsor charges fees and expenses for managing the properties. Finally, if you prefer an active investment approach, a DST might not be a good fit.

Who May Be a Good Fit for a 1031 Exchange

1031 exchanges are becoming more popular and are fitting into a wider variety of use cases. Some individuals who may benefit most include:

Estate Planning Purposes:
Investors who are above the estate tax exemption limit can use a 1031 exchange to defer capital gains taxes, allowing their heirs to inherit the property at its stepped-up market value.

Active Real Estate Investors:
Those who regularly invest in real estate can continually use the 1031 exchange strategy to defer capital gains while compounding their investment returns.

High Net Worth Individuals:
Investors in high tax brackets can minimize tax liabilities and better control cash flow for other investments through a 1031 exchange.

If you have a property you’re considering for a 1031 exchange, reach out to your financial advisor to explore how the process may work for your situation.

Raymond James Financial Services, Inc. does not provide advice on tax or legal issues. These matters should be discussed with the appropriate professional.