How To Use The 1031 Exchange To Avoid Taxes In Real Estate Investing

We’re not here to tell you you need to do one. What we are here to do is explain how they work and when they’re appropriate, whether they’re pitfalls, so that you can decide whether or not a 1031 exchange is right for you.

Saying that, let’s dive in. Jonathan, what the heck is a 1031 exchange? Why are we even talking about this?

Jonathan: Sometimes they’re called like-kind exchanges. If you really want to get into the nitty-gritty, you can read publication 544 from the IRS, but we’re just going to be hitting the high points today.

Generally, though, I like to look at 1031 exchanges as a really powerful tool in your tax toolkit that you can use to develop your real estate investing even further. It’s all about developing that portfolio in a way that’s more tax efficient than selling a property that you may not like or may not be performing and then trying to buy a replacement property. That route tends to allow the IRS to take a big bite out of your equity and make it a lot harder to get that portfolio rolling the way you want it to.

Toby: A 1031 exchange in a nutshell is basically, I can trade real estate that I’ve purchased that’s gone up in value and by equal or greater value real estate. It can be 1 piece, 10 pieces, different types of real estate. I could sell a commercial property and buy 20 single family homes. As long as I’m buying real estate, then I can avoid tax on both the capital gain and the recapture. Is this what we’re talking about?

Jonathan: Exactly. Essentially, it lets you push it forward into the future, where you have more opportunities to plan for it. Another great option that I’ve seen people using recently is pivoting their investing strategy. A lot of jurisdictions out there, cities and counties are starting to really clamp down on short term rentals. A lot of short-term rental investors are pivoting to boutique hotels. This is a really great way to roll that equity from the short-term rentals into this new investing opportunity without getting that tax hit.

Toby: But it’s just real estate to real estate. It doesn’t matter whether it’s land, condo, single family, commercial. As long as I am going real estate and buying more real estate, then I can avoid having to pay tax on the real estate I just sold. Is that a fair analysis?

Jonathan: Right. That’s the first big rule. It does have to be real estate, and it does need to be real estate that you’ve held for investment or business use. It can’t be personal residences, secondary homes, or those sorts of things.

Toby: Perfect. It’s an investment property. How does it work? Can I buy a new property and then 1031? Or do I have to always 1031, like sell the property first and then acquire one?

Jonathan: It’s a little tricky in that sense, because you initially want to just sell the old property and buy a new one. But with the 1031, technically, you can’t get your hands on the proceeds. Timing is really important, and the way that you carry out the exchange is really important.

What you need to have is a qualified intermediary who acts like a middleman. Sometimes they’re called an accommodator or facilitator. They’re basically there to carry out the transfers on your behalf. You never actually get your hands on the proceeds. You don’t get stuck with that sale treatment and the taxes that come out of that.

Toby: Okay. What’s the good use of a 1031 exchange? What’s appropriate? What are the rules? Give us the thumbnail sketch of how these things work, typically, for people.

Jonathan: The first big rule we already hit on, it’s got to be real estate, it’s got to be held for investment or business use. You’ve got to have that qualified intermediary in there, making sure that you’re dotting all your Is and crossing your Ts.

The next big thing to keep in mind is timing. There are two big deadlines that sometimes surprise people. There’s the exchange period, which is 180 days overall from closing on the old property to closing on the new property. You’ve got to be within that 180 day period or the exchange fails, and you get stuck with the recognition of those taxes we want to avoid.

The other deadline is known as the identification period. That starts up when you close on the sale of the old property, and then you have 45 days to identify the new one. That runs concurrently with 180. If you take right up to the 11th hour or the 45th day to identify the new property, you’ve only got 135 days left to close on it.

Toby: Is it just one property you get to identify? Can you do multiple? Or are there percentage tests? What are the rules?

Jonathan: The default test lets you hedge your bet a little bit just in case one of the properties you identify may be something that comes up when you’re doing your due diligence, and that ends up not being a viable option. You can actually identify three properties, you just have to close on at least one of them. Close on one, two, or three, but you can’t close on anything that you didn’t identify. That’s the big rule about acquiring that property at the end of the day.

Now, if you want to hedge your bets even more, there are other rules that you can use, like the 200% rule and the 95% rule. They’re not quite as common, but they can come in handy if you’re looking for more flexibility.

Toby: How does that work? Let’s say that I’m going to use the 200% rule. Can identify a whole bunch of properties, and it can’t be worth more than twice as much as my house that I’m selling or the property that I’m selling?

Jonathan: Exactly. The 200% rule says that you can identify several properties as long as the combined fair market value of all of those properties doesn’t exceed 200% of the old property you’re giving up. Usually, you’ll want to shoot for something more like 180%, maybe 190%, just in case one of those appraises a bit higher than you’re expecting. Because if you go over the 200%, it blows up the 1031.

Toby: I’m going to embellish on one thing that you also discussed a little bit ago. The common is the starker exchange when you’re selling something, buying something, but it is possible to buy something and then sell something. Still, to use a qualified intermediary, it’s called a reverse exchange.

There are some other little nuances too. You could actually sell to a family member and things like that, but then there are extended periods of time to hold on to it. There are little nuances, but 90% of the time, the vast majority of what you’re seeing are those like-kind exchanges. That’s what they’re known for. That’s what people tend to use them for.

The big one that Jonathan said is the qualified intermediary. You have to make sure you do not touch those funds. Touch on the debt. Can I just pay off the debt? What do I have to do about the debt? Do I have to leave a mortgage there? What if I don’t have a mortgage and then I buy a property with a mortgage? What happens to me? Are there other bad things that occur? Give me the lowdown on those two.

Jonathan: This plays into that very first role, where when you’re exchanging, it’s got to be real estate for real estate. It’s got to be that qualifying use real estate, where it’s used for business or investment purposes. If you get any other benefit back out of the exchange, like a reduction in debt, or you get some cash back out of it because the new property’s worth a little bit less than what you’re rolling forward, that’s called boot. It’s not treated as like-kind, and then you’re taxed on the fair market value of that.

Basically, if you end up with less debt than you had with the original property, you’re going to be taxed on whatever that reduction in debt was. That’s known as mortgage boot, and that can sometimes be a nasty surprise.

Toby: So make sure that you work with a qualified intermediary. There are things you can do. Sometimes you can pay down that mortgage ahead of time and things like that. There are ways, but what you can’t be doing is doing an exchange, end up with a bunch of cash in your pocket, and think that you’re not going to have a tax hit, or other benefit, or have the mortgage paid off somehow some way through somebody else. You just have to be careful about what type of benefit you get out of this. Make sure that it’s property for property.

What are the downsides, the big downfalls that you see people hit? You hit on one of them. I imagine that it could be a little bit frustrating if you are the seller of a property, and now you identify something else and you want to close, somebody drags their feet, and they know you’re doing a 1031 exchange trying to get some more money out of you possibly, or they know you’re going to have a tax bite as a result that there might be some gains.

I know that that’s floating out there, and that’s going to be really frustrating. That’s why you pick multiple properties. What are the other big ones that you see that are common, that hurt people that we need to be aware of?

Jonathan: One big one is making sure that when you do identify a property, you close on that property. The IRS wants it to be substantially similar. They’ve got a few examples of what does and doesn’t fly. They’ve got this one about acquiring two acres of agricultural land and they’ll say something like, if you acquire an acre-and-a-half of it, 75% of what you identified, that’s okay.

If you build a fence on it once the period when you identify it close on it, that’s okay. But if you close on just the barn and not the rest of the two acres, the nature or character of the property changed enough that they’ll say that’s not a like-kind exchange anymore. You just want to make sure that you’re closing on as close to what you identified as possible.

Toby: When you’re identifying, is an address enough? Is a parcel number? What actually qualifies?

Jonathan: It’s pretty straightforward. You’re basically just officially stating, this is going to be my replacement property for purposes of this 1031. If you get the address on there, that’s sufficient. If it’s a condo, you want to include something like the condo number. If it doesn’t have an address, legal description works. You just want it to be fairly clear that that is the property you identified. There’s never any question as to whether or not you’ve got the right property at the end of the day.

Toby: Who are you giving notice to? Is it just a qualified intermediary? Or is there a document you have to submit to the IRS?

Jonathan: The qualified intermediary is the most common answer. Usually, they’ll just have a template that they’ll put together for you to make it really easy. But technically, you could identify or give your identification to anybody involved in the sale, who’s got either the duty to turn the property over to you like the seller, maybe their broker, or an attorney involved in the sale. But typically, you just go with the qualified intermediary to keep it simple.

Toby: They’re the ones who have to do all the documentation of this, and they’re the ones handling the money. Make sure it’s the qualified intermediary. It sounds like you’ve noticed somebody else, but make sure that the QI knows.

By the way, Jonathan and I are not QIs, so we don’t have a dog in this fight. But I see a lot of QIs getting out there. They talk about transactions that are really gray areas that run a lot of risk. You’re looking at it going, woof, but they’re selling a service. Maybe with that complexity, they get a higher fee.

What if somebody looks at it? If they’re looking for a qualified intermediary, are there certain qualities that you’re looking at? Are there certain groups? What advice can you give somebody?

Jonathan: The tricky thing about QI is they’re not regulated the way that brokers are, attorneys, or CPAs are. It’s a little bit of a wild west out there. You’re going to want to do a bit more due diligence when you’re picking one out. If you’ve got a good relationship with an attorney or a CPA, and then you’re looking to do a 1031, ask them if they’ve got somebody they’ve worked with and vetted before. And that’ll be a good option for you.

If you’re an Anderson client, we do have a QI that we recommend, that we’ve checked out, and they’ve done good work for clients in the past. We’ve got somebody we can recommend to if needed.

Toby: Of course. What are some other pitfalls? Or have you seen any 1031 exchanges that you’ve read about, that ended up collapsing for what reason? Are there any common situations where somebody’s going to be like, oh, don’t do that?

Jonathan: One that comes up a lot is, when someone’s trying to dress a property up as an investment or business property, when really what’s at the heart of the matter is they’re trying to exchange a personal property. They’ll do something like try to rent it out really quick before they sell it, then rent the new property for a little bit, and turn it back into their residence. You want to be really careful doing anything like that.

Generally, you want to make sure that you’ve got at least a year of qualifying use before and after the exchange so that you’ve got that documented on those tax returns, just in case there’s ever pushback.

Toby: Is there a hard rule on that? Because I’ve heard so many different things. I’ve talked about it for years that you can actually 121, which is the capital gain exclusion on your primary residence, turn it into a 1031 exchange by making it into an investment property, selling it to go acquire another investment property. In theory, yes, you could convert that back to a primary residence at some point. The rules actually anticipate that.

In fact, under 121, there is a five-year hold period, I believe, for 1031 property that turned into a primary residence. There’s not a prohibition against it. Is there a hard-and-fast rule on these? Or is it just up to interpretation, the IRS is looking at it going, is this really an investment property, you’re just trying to not pay tax on something?

Jonathan: A lot of it comes down to looking at the intent. You want to be able to show that you had the right intent. There is that flexibility that you mentioned. Absolutely. You just want to make sure that it doesn’t look too fishy.

They’ve tried to establish a hard rule for a holding period a few times, I believe it’s at least twice. Both times, they were positioning that one year rule, and neither time it’s stuck. As far as we know, it’s still gray. But given what we’ve seen in the past, that one year seems like a safe spot.

Toby: People use that one year rule, but there is no one year rule. A lot of times, I see people that are going to 1031 a property that they bought with the intent of having it as a hold, and then somebody comes up and offers them a deal that they can’t refuse.

Somebody says, well, you can’t do it, you’ve only owned it for nine months. You have to own it for at least a year. They’re looking at it like, oh, man, no, you don’t. As long as when you purchased it, it was investment property, and its current use is investment property. Sell that sucker, 1031 it, take your payday, and buy something else.

Jonathan: Absolutely. It really boils down to that intent. The one year rule, like you said, is not technically a rule. It’s more of a safeguard, I guess you could say, a more conservative approach to it, but absolutely. If the right deal comes along and you’ve had the right intent the whole time, by all means go ahead with it.

Toby: All right. How about a Delaware Statutory Trust? I’ve heard of those. How do they mix them with the 1031? Are you familiar with them? If so, how does it work?

Jonathan: They’re a really interesting investment option for people who are looking to pivot away from. Maybe they’ve got something like a single family home, and it hasn’t really been working very well for them. They’re all invested in this one little property, so their risk is pretty heavy because of that.

They find out about these Delaware Statutory Trusts, and one of the big perks is you can exchange into the Delaware Statutory Trust if you’re buying a replacement property and get the same tax deferral benefits. But the statutory trust is spread out over several different properties, several different classes of properties, so all of a sudden, you’re in a much safer position. You’ve got investments across the country through the DST.

Toby: I can 1031 a property. Let’s say I have a rental property, maybe I have a four-plex. I want to sell it and be out of the landlording business, but I still like real estate. Then I could do a DST and avoid tax on the depreciation recapture and the capital gains, and I can come out smelling like a rose, right?

Jonathan: Absolutely.

Toby: All right. How about if I am in a syndication? Can I 1031 exchange my interest in that syndication?

Jonathan: Fractional interests in real estate are a little trickier. If you think about it, it’s got to be a real estate interest at the end of the day. Often, people run into this if they’ve got something in a partnership or an LLC, and not all the members want to do a 1031. In that case, they’ve got to do something like set up a tick, sometimes called a drop and swap, where they’re actually changing the way that the property is owned.

It’s not in a business entity anymore. They’re not trying to exchange membership or partnership interest, it’s still an interest in real estate. As long as you’re doing the proper planning ahead of time, you can work around that. Just know that there is going to be a little bit more work involved in carrying that out.

Toby: The exchange always has to be name to name. If you have an LLC and you’re doing a syndication, in order for you to be able to 1031 exchange that interest, and your interest is held in LLC, the LLC is the new buyer. It has to go name to name. The LLC sells it and buys it, and you have to have everybody on board. If they’re not, then you just said that there’s drop and swaps, and there’s swap and drops.

These things where they do a little bit of a buyout, and maybe somebody wants to exit a deal, and they’re okay with the tax hit, but you still want to do an exchange. Maybe you go through the exchange, then you buy out that individual, give them some cash, and they pay tax on their gain themselves, but you keep it. Or like you just said, you take it out of that LLC, drop it into a tenant in common arrangement, and now everybody has an interest in real estate.

I’m not aware of there being any holding. If it’s the same entity, same beneficial owners, they lop it all together. It’s the same thing in a starker exchange. When somebody sells a property, buys it in their own name, and then they’re afraid to put it in an LLC because they’re like, oh, they’re going to undo my exchange, it’s not how it works. They’re looking at the beneficial property holder. But there are those little nuances. What nuances am I missing? Is there anything else out there that these guys should know?

Jonathan: What we do here at Anderson is we focus a lot on asset protection structuring. Sometimes that can add some wrinkles to a 1031 analysis, where maybe you’re changing jurisdictions. You’ve got a property in Florida, and you’re swapping for property in California, that structure could look pretty different under an ideal approach. From an asset protection point of view, you’re not going to structure Florida property the way you do a California property.

You have to be careful, because like you said, you have to have the same taxpayer on both ends of the deal for at least a period of time to show that you’ve got that proper intent. You don’t necessarily want to jump right into a 1031 without talking through your structure a little bit and having a game plan for it.

Toby: I think that you’ve hit all the major topics here and that you’re giving everybody a really good wide view of what a 1031 exchange is, how they’re good, how they’re bad. Is there anything else that we didn’t cover that you want to throw it out there, or did we hit it all?

Jonathan: I think that’s pretty good for the high level view that we’re going for today.

Toby: Perfect. Guys, if you liked this, share it with other people. Give us a subscribe, give us a like, it helps our algorithms. If you know anybody who’s going to do a 1031 exchange, send this to them so they’re actually going in with their eyes open.

Qualified intermediaries vary in quality. Sometimes you have some folks out there that work for a company, and then they’re getting paid to act as a QI, but it doesn’t actually work the way they’re doing their transaction, and you get in some hot water. At the end of the day, if there’s a mistake, you’re the one who’s holding that bag.

Make sure that you learn the rules and you’re talking to somebody who’s giving you good guidance. If there’s anything else we can do to help, put it in the comments or reach out to us absolutely, and we’ll point you in the right direction. Thanks, Jonathan, for covering the attorneys’ guide to 1031 exchange.

Jonathan: Yeah, thanks for having me on.