What is a 1031 Exchange? A Guide to the Tax Advantages & Estate Planning Benefits

As a real estate investor, maximizing returns and minimizing tax liabilities are key priorities in building a successful portfolio. One powerful strategy that investors often utilize is the 1031 exchange, named after Section 1031 of the Internal Revenue Code that allows for the deferral of capital gains taxes on the sale of investment properties. This section of the code states in part, “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” What many people don't know is that this 1031 exchange is also a powerful estate planning tool that can help you preserve the amount in your estate that you pass to your heirs. While this may sound complex, below we breakdown what a 1031 exchange is, the significant tax benefits it offers to real estate investors, and the benefit to using 1031 exchanges in your estate planning.

*Please be advised that nothing in this article is intended to be used as specific tax advice. Lane, Lane & Kelly, LLP is not a certified Tax Specialist. For specific questions, please contact a qualified tax expert or accountant. The information in this article is intended for educational purposes only. 

What is a 1031 Exchange?

A 1031 exchange, also known as a like-kind exchange or a tax-deferred exchange, is an investing tool that allows real estate investors to defer paying capital gains taxes when selling one of their investment properties. The 1031 Exchange allows the investor to “exchange” the proceeds of the sale of the property and reinvest those proceeds into another property of equal or higher value. The proceeds must be put toward a “like-kind” property, meaning the property is of similar nature and value. This “like-kind” standard is pretty broad, and requires only that the property be of equal or greater value, it is held for investment purposes, or used in a trade or business.

Because the initial sale does not result in a profit, there is no income tax to be paid. Instead, you opt to put your potential profit that would otherwise be subject to capital gains tax, and instead put those proceeds from the sale of your relinquished property (sometimes called the downleg) towards the purchase price of a new replacement property (the upleg).

Important Details About the 1031 Transaction

Just like with all real estate deals, when it comes to a 1031 Exchange, timing is everything. When selling a property, you have 45 days from the closing or the date that the official transfer of title occurs to the identify your replacement property. From there, you have an additional 135 days to close on the new property, giving you a total of 180 days to complete the exchange.

For most investors, the difficulty arises in the initial 45-day identification window. With a competitive real estate market, this tight turnaround time can lead to pressure to find a new investment property in under two months.

It is also important to note that the same entity must take title to the replacement property in the same manner they held the relinquished property. This means that if an LLC (limited liability company) held title to the initial property, then that same LLC must execute the exchange and hold title to the new property. Click here to read more about the benefits to holding real estate in an LLC. There is no limitation on the entity that is used however, whether it be an individual, an LLC, a corporation, a partnership, a trust, etc. The only requirement is that the previous ownership structure be preserved in the purchase of the replacement property.

You will also need a qualified intermediary (QI), which is sometimes referred to as an exchange facilitator, in place before the closing of the new property. The QI is a third-party that cannot be your real estate broker or attorney, that holds the proceeds of your sale in escrow until the official exchange is complete. A requirement to complete the 1031 exchange is that this QI receives your funds at closing, so they can be held in a separate, insured account until your next property is identified during the 45-day window. Once the replacement property is identified and both parties are ready to close, the QI then releases those funds to the escrow company to finalize the purchase of the replacement property.

Key Benefits of a 1031 Exchange

• Tax Deferral: The primary benefit of a 1031 exchange is the ability to defer paying capital gains taxes on the sale of an investment property. By reinvesting the proceeds into a new property of equal or greater value, investors can defer taxes until a later date, allowing them to preserve more capital for future investments.
• Portfolio Diversification: A 1031 exchange provides investors with the opportunity to diversify their real estate portfolio without incurring immediate tax consequences. Investors can exchange properties in different geographic locations or property types to enhance portfolio diversification and optimize investment returns.
• Increased Buying Power: By deferring taxes through a 1031 exchange, investors can leverage the full proceeds from the sale of their relinquished property to acquire a higher-value replacement property. This can lead to increased buying power and potential for higher returns on investment.
• Investment Consolidation: 1031 Exchanges can be used to consolidate several different properties into one. Similarly, it can be used to sell one investment property and put the proceeds towards the purchase of several other properties. There are additional rules however if you are purchasing more than three investment properties.
• Many investors will use a 1031 Exchange to turn their vacation home into a rental property. You can take your current beach house or second home, rent it out to establish income generated from the investment property (at least 14 days), and then exchange it for an entirely new rental property through a 1031 exchange.

Utilizing a 1031 Exchange in Your Estate Plan

These types of exchanges can also be used as an estate planning tool to preserve the amount that you pass to your heirs. If you hold an investment property and were to sell it outright in order to pass the profit to your children, you would pay approximately 25-40% in capital gains tax to the government. Instead, you could sell your current investment property as the downleg and use your profits towards the purchase of a new upleg investment property. In doing so, you defer 100% of the capital gains tax that would otherwise be due.

The added benefit is that your heirs would also receive this tax deferment if you were to die while owning this new investment property. Your heirs get a stepped-up basis that passes the value of the investment property based on the date of your death, not the date that you originally purchased the property or even the previous investment property used in the 1031 exchange. Upon your death if your children then wanted to sell the investment property, they would pay no capital gains tax on the property at all. There are ways to leverage 1031 exchanges in your estate plan in a more proactive method as well. Let’s use an example to illustrate this.

• Mike owns an apartment building in South Boston currently appraised at $1,000,000. Mike has two children, Sara and Jon, and after speaking with them, neither has any interest to own or manage the apartment moving forward. Mike then sells the South Boston apartment building (relinquished property) as part of a 1031 Exchange and uses the proceeds to purchase two new investment properties that are each worth $500,000. Since the total value of the two new properties is equal in value to the relinquished property, this transaction falls withing the 1031 guidelines.
• Mike then works with his tax advisors and estate planning attorney to place each property in a revocable trust. Mike names Sara as the beneficiary of the Trust holding property A, and names Jon as the beneficiary of the Trust holding property B. When Mike ultimately passes away, the trust property automatically transfers to each child, with a stepped-up basis equal to the value of the commercial property at the time of his death
• This method allows Mike to ultimately transfer the value of his commercial property to his children, without him or his children having to pay for the capital gains that otherwise would have been due. Even if Sara and Jon then decide to sell these new properties immediately after Mike dies, they pay no capital gains tax since the built-in gain from the 1031 exchange disappears upon the taxpayer’s death.

Navigating a 1031 exchange requires careful planning and adherence to IRS regulations. Investors are strongly encouraged to work with qualified tax advisors, real estate attorneys, or qualified intermediaries (QIs) experienced in facilitating like-kind exchanges. These professionals can provide guidance on structuring the exchange, ensuring compliance with IRS rules, and maximizing tax benefits.

In summary, a 1031 exchange is not only a valuable tool for real estate investors seeking to defer capital gains taxes and optimize their investment return, but it is also a beneficial estate planning tool that allows investors to avoid paying out a large portion of their investment gains in taxes. By leveraging the benefits of a 1031 exchange, investors can enhance portfolio diversification, increase buying power, preserve capital for future investments, and leave more of their assets to their loved ones. If you're considering a 1031 exchange or want to learn more about tax-efficient real estate strategies, contact our experienced real estate attorneys at Lane, Lane & Kelly, LLP. We're here to help you navigate complex real estate transactions and achieve your investment goals.

This blog is made available for educational purposes only as well as to give you general information and a general understanding of the law, not to provide specific legal advice. By reading this blog you understand that there is no attorney client relationship between you and Lane, Lane & Kelly, LLP.

Please be advised that nothing in this article is intended to be used as specific tax advice. Lane, Lane & Kelly, LLP is not a certified Tax Specialist. For specific questions, please contact a qualified tax expert or accountant. The information in this article is intended for educational purposes only.