
Mastering 1031 Exchanges: How to Defer Taxes and Build Real Estate Wealth
Are you thinking of selling your investment property and cashing out? Before you do, consider the impact on your profits. According to the Riverside County Assessor’s Office, the average home price in Riverside County for 2023 was $615,000. If you sell an investment property at that value and make a profit of $300,000, failing to reinvest through a 1031 exchange could lead to a tax hit of around 33.3% (20% federal capital gains tax plus 13.3% California state tax). That’s a staggering $99,990 in taxes—funds that could instead be used as a down payment on a new investment or even to help family members begin their real estate journey.
So what are 1031 exchanges, and why is knowing what they are before you sell your investment property essential to protecting your wealth? In this article, we’ll break down the basics of 1031 exchanges, explain what they are, and why they’re a crucial strategy for anyone considering selling an investment property.
What is a 1031 Exchange
A 1031 exchange, named after Section 1031 of the U.S. Internal Revenue Code, is a tax-deferral strategy used by real estate investors to defer paying capital gains taxes on investment property sales. By reinvesting the proceeds into another “like-kind” property, investors can continue building wealth while deferring tax obligations.
This tax-deferral tool especially benefits those looking to upgrade properties, diversify portfolios, or adjust investment strategies without incurring an immediate tax burden. However, strict rules govern the timing and nature of the exchange, so it’s essential to work with experienced professionals to navigate the process successfully.
What are the Requirements for a 1031 Exchange?
The primary requirement is that the replacement property must be of an equal or greater value than the property you are selling.
Additionally, there are strict timeframes within which the replacement property and the sale property transactions must occur. We’ll learn how these timeframes apply depending on the type of 1031 exchange you’re undertaking below..
Types of 1031 Exchanges
1. Simultaneous Exchange
A simultaneous exchange occurs when the property you sell and the property you purchase close escrow on the same day. This type of exchange is also called a “drop and swap exchange”. Before the 1980s, all exchanges were simultaneous.
2. Delayed Exchange
A delayed exchange is the most common exchange. A delayed exchange occurs when you close escrow on the property you sell but have not identified the property you wish to buy yet.
In these cases, to qualify as a 1031 exchange, you must identify the purchase property within 45 days of the sale escrow date. Afterward, the purchase must close within 135 days following the sale escrow date. In effect, then a delayed exchange applies where you complete the purchase transaction within 180 days of the sale transaction.
3. Reverse Exchange
A reverse exchange is very similar to a delayed exchange; however, a reverse exchange is when you acquire the replacement property before selling your current property.
Like the delayed exchange, you must identify the sale property within 45 days (giving investors with multiple rental properties time to evaluate which property they wish to sell) and close the transaction within 135 days, for a total grace period of 180 days.
4. Improvement Exchange
An improvement exchange, also known as a "build-to-suit" or "construction" 1031 exchange, allows investors to defer capital gains taxes by reinvesting the proceeds from a sold property into a new property that will be improved or built to suit their needs.
Unlike a standard 1031 exchange, an improvement exchange enables the taxpayer to use exchange funds to purchase a new property and cover construction or renovation costs. The unique advantage here is that the improvements count toward the total value of the replacement property, helping to meet the “equal or greater” value requirement of the 1031 exchange rules.
However, all improvements must be completed within the exchange’s 180-day timeline, and the taxpayer must adhere to strict regulations, typically working with a qualified intermediary who holds the improvement funds and manages the process. This strategy is popular among investors seeking to customize new investments, upgrade assets, or even build from the ground up without incurring immediate capital gains taxes.
Professional Resources for 1031 Exchange
To have a successful, stress-free exchange, it’s essential to have a knowledgeable team behind you. It’s a good idea to enlist the help of the following professionals:
- CPA
- Qualified Intermediary (QI), like a title company
- Real Estate Agent or Broker
- Financial Advisor (possibly)
- Real Estate Attorney
Frequently Asked Questions about 1031 Exchanges
Can I live in my 1031 Exchange Property?
A. Yes, you can eventually live in a 1031 exchange property, but specific rules apply. Initially, the property must be used as an investment or for business purposes to qualify for the tax deferral under 1031 exchange rules. This means you’ll need to rent it out or use it in a way that generates income for a period of time. The IRS generally recommends holding the property for at least two years in an investment capacity to demonstrate clear intent. After that period, you may convert the property to personal use, following what is known as a "qualified use" period.
If you decide to convert it to a primary residence, keep in mind that if you eventually sell it, you'll need to meet certain conditions to qualify for any exclusions on capital gains taxes, such as living in it for at least two of the five years preceding the sale. However, the amount of gain you can exclude may be limited, and some of the deferred capital gains from the original exchange could still be taxable. Consulting a tax advisor is always a good idea to ensure compliance with all IRS regulations in this type of scenario.
What is the cost of an Exchange?
A. Typically, around $1000, and the QI (Qualified Intermediary) can make interest on your money until it goes into the property you’re buying
Can I do an exchange with a family member?
A. This raises RED Flags with the IRS. It can be done, but there are specific rules that must be followed. We recommend against it.
Can I sell one property and buy three more?
A. YES, as long as you meet the exchange requirements you are undertaking.
Can I sell a Single-Family Home and buy a 4-plex?
A. YES, as it’s considered a like-for-like exchange; that is, you're exchanging an income property for an income property.
Real-Life Example of a 1031 Exchange
An Investor sold an office/industrial complex for $2,500,000. The investor used the proceeds to purchase another commercial building and two single-family homes. Since the investor reinvested in other income-producing investment properties, the investor avoided $500,000 in capital gains tax.
Generational Wealth
We have all the resources you need to complete a successful exchange and save you hundreds of thousands in capital gain taxes. Thus, you can create generational wealth for yourself, your kids, and your grandkids.