Interested in a 1031 Exchange? How to Sell Your Rental Property without Paying Capital Gains Tax

What is a 1031 Exchange?

A 1031 Exchange, also referred to as a “Like-Kind” or “Starker” Exchange, can be found under section 1031 of the IRS code. In summary, a 1031 allows for someone (usually an investor) to defer making capital gains taxes on a property once it’s sold. The catch is that the property must be swapped for a similar property- meaning: if you sell one investment property for a profit, you must use that profit to purchase a like-kind property. Rental owners can potentially make a significant amount if they own a rental property that was purchased a long time ago (and therefore, will sell for a significant more) via a 1031 exchange.

While there are a lot of upsides to doing a 1031 exchange, there are also many rules that must be abided by in order for your 1031 to go smoothly. For example, what is considered a “like-kind” property? We’ll dive into all of this below.

Here is where you can find California’s filing requirements:

What are the 4 Types of Real Estate 1031 Exchanges?

  1. Simultaneous exchange. A “clean swap” is possible if the person you are purchasing a property from wants the exact property you own. In these cases, of a clean swap, you can close on the replacement property in an incredibly short amount of time- as soon as a day. But, this is also one of the least likely of exchanges to take place simply because the chances of finding a property you want to buy from someone who wants your property is pretty slim. But, you never know!!
  2. Delayed Exchange. This is the most popular kind of exchange for investors because it allows 180 days post-sale to find and purchase a replacement property with the profits (without paying any gains taxes). This process requires that a third party, usually a qualified intermediary, “holds” the cash after you sell your property and then uses the escrowed cash to buy your replacement property.
  3. Reverse Exchange. This kind of exchange allows you to pay the taxes later down the road. These transactions are said to be more difficult for two reasons: 1) the purchase must be in all cash, and 2) getting a loan with your name on the title for your current and replacement property is nearly impossible. The workaround here is that you can create an LLC to purchase your replacement property under, then transfer the title to your name once your current property is sold.
  4. Construction/Improvement Exchange. Finally, there is the improvement exchange. In this case, you can purchase a home that is less than the one you are selling and use the profits to invest in improving the property you’re buying (without paying taxes).

In general, the following are rules that must be abided by when doing a 1031 exchange:

  • Like-kind property (is actually quite broad- you can even swap an apartment building for empty land!).
  • Investment or business property only (basically, it can’t be your primary residence serving only the purpose of being your home).
  • Greater or equal value (hint: if the property your replacing current sale with is less in value, then use the profits to “improve” it via the Construction/Improvement Exchange).
  • No “boot” (if you have cash leftover, you have to pay for it).
  • 45-day identification window/180-day close date (see below for additional details).

Without going into too much detail, we’re going to focus on some of the more important “rules.” The first: the 45-day identification window requirement. This really is just as it sounds. After closing on your current property, you have 45 days to identify the replacement property for purchase. If you do not identify the replacement property by midnight on the 45th day, then the exchange will fail and you will not be able to defer capital gains taxes. This written identification must be signed by a professional party such as your agent or attorney. Tip: you can actually designate up to three properties in writing, and just need to close on one of them.

There is also a 180 purchase day window. This rule runs alongside the 45-day rule but basically states that you must actually acquire your replacement property by this time. To be clear- an Agreement of Sale will not suffice, you must have legal ownership of the replacement property.

What doesn’t qualify for a 1031 Exchange? If the property being purchased is held as an investment or for business use, then it DOES qualify. A property does NOT qualify when it is your primary residence not being used for business or trade etc. Business inventory of “dealers” who turn residential properties for a profit (or purchase with the intent to sell) are also excluded from the 1031 Exchange.

 Interested in Selling Your House & Doing a 1031 Exchange?

There are so many success stories that as a real estate service provider we have been witness to in regards to 1031 exchanges. Despite the rules that may feel restricting, there really is a ton of flexibility and freedom offered by a 1031 Exchange as long as you do it right and understand the process. For most, you’re best off if you’re trading up. By this, we mean that if you’re selling a small single family property, your later purchasing another property that has a higher purchase price. What you’re exchanging the property for doesn’t have to have higher square footage or be larger in size, but the price should be higher. Basically, you don’t want to end up with cash leftover from the profit of your sale because you will have to pay taxes on it (as they say, “don’t end up with boot”).

One of the more memorable success stories we dealt with in helping a seller through a 1031 exchange was a woman selling her rental property in San Diego, and then turning around and buying THREE rental properties in the state she then resided in (which happened to be Texas). While the purchase price of each replacement property in Texas was not equal to or greater than the price of her sold San Diego rental, their sum was. With a 1031 exchange, you’re allowed to buy more than one property to make up the “like-kind” property rule.

Because a 1031 exchange is not for everyone and does require some long-term planning, we do recommend speaking to a real estate professional or your personal accountant. Here at Sell Your House Direct, we have home buying specialists who can walk you through the process and your options as well. If you think a 1031 Exchange is your next move and you have a rental property you’d like to unload for another, we’d be happy to help you on your way to having those capital gains taxes deferred!