A 1031 exchange involves two critical moving parts. One property is purchased, and the other is sold. Some investors hold these properties indefinitely, passing the assets to their heirs when they die. Others need to sell the properties they acquire, and that can come with some challenges.
In this article, we’ll explain what happens when you sell a 1031 exchange property, and we’ll outline what you can do to avoid common mistakes and pitfalls.
What Is a 1031 Exchange?
Before we dig into what happens when you sell a 1031 exchange property, let’s recap what these transactions are.
A 1031 exchange allows investors to trade one property for another and roll the potential tax liability from the purchase into the sale. That tax liability isn’t forgiven, but it’s not due immediately. In fact, if you never sell the property and pass it to your heirs when you die, the bill never comes due.
What Are the Benefits of a 1031 Exchange?
A 1031 exchange is a complex transaction that requires outside help. It’s much more complicated than simply selling a property and buying another one. However, a 1031 exchange provides benefits that standard transactions just can’t touch.
For example, a 1031 exchange allows you to roll potential capital gains tax into the new property. As we mentioned earlier, those tax liabilities don’t disappear entirely. You must track your basis in the new property and pay at least part of those taxes when you sell. However, if you need to make a switch without an immediate bill, this is a good option.
A 1031 exchange also allows you to diversify your holdings from one property to multiple. For example, you may have a large asset (like an office park) that is under-performing, but single-family rentals are hot in your market right now. With a 1031 exchange, you could sell one item and buy multiple properties, all within the same transaction.
Since these deals come with so many benefits, plenty of investors use them. In fact, up to 20% of all commercial real estate transactions involve 1031 exchanges.
What Are the Steps Involved in a 1031 Exchange?
A 1031 exchange involves the sale and purchase of properties in a dependent transaction. These are the typical steps involved:
1. Hire a Qualified Intermediary
Per IRS rules, you can’t handle all parts of a 1031 exchange by yourself. Instead, you must hire an outsider (a qualified intermediary) to help you. This person accepts the funds from the sale of one property and releases them for the sale of the other. As a result, the investor never touches the funds directly and doesn’t incur a tax penalty.
2. Sell a Property
With your qualified intermediary hired and ready to help, you can sell an item within your portfolio. The asset you choose must be used for business purposes, so things like the family home you live in all the time don’t qualify.
When the sale is complete, the funds are parked with your qualified intermediary. This step is crucial to ensure the transaction is valid.
3. Identify a Property
Per IRS rules, you have 45 days from the date your property is sold to formally indicate the property (or properties) you’ll purchase as part of the exchange. You must deliver a written statement that outlines things like the address, legal description, or distinguishable name of the properties you’ve identified.
4. Purchase that Property
Per IRS rules, you must close the purchase of your identified properties within 180 days of the sale of the other asset. Your qualified intermediary makes this possible by transferring the funds held from the sale. At this point, your exchange is complete.
5. Defer the Taxes Until You Sell
When your exchange is closed, the recordkeeping begins. The IRS requires investors to track the basis in their new property and the taxes they’ve deferred. If you choose to sell the property, the original deferred gain, plus any additional realized gain, is taxable.
What Happens When You Sell a 1031 Exchange Property
The IRS doesn’t require you to hold a 1031 exchange property indefinitely. It’s perfectly legal to do so—and it’s sometimes necessary. However, there are some risks involved with selling something you purchased via an exchange. These are a few of the most common challenges:
Taxes May Be Due
When you sell a property acquired via a 1031 exchange, the deferred gain and any additional gain become taxable. This is a common scenario, as up to 88% of exchanges ultimately result in taxable income.
You May Be Audited
IRS documents don’t include rules about how long you must hold property. However, the government does require that properties bought and sold in exchanges are used as investments. If you hold a property for at least two years and have a paper trail about the money you’ve made during that time, proving intent is easy. If you sell sooner, you could trigger IRS attention, and you’ll need to produce proof that your investment was legitimate.
You May Choose to Reinvest
You’re not required to sell a property acquired via exchange for profit the next time around. It’s perfectly legal to sell this property in another exchange. Doing so can help you defer the original taxes again, and you’ll defer the taxes on this sale too. If you want to keep your investments active and working for you, this can be a smart strategy.
You May Keep the Profits
Some investors have a run of bad luck and want to get out of the real estate market altogether. If your property is losing money, you may not make much on the sale. If you bought it and delayed a small amount of taxes, you may not owe very much. In situations like this, selling could be a smart way to get out of a market that’s not working and into something more profitable.
What Should You Consider?
Take your time when determining what to do with property purchased via a 1031 exchange. Consult with your financial team and consider the following factors as you decide what to do with your investments.
Your Potential Tax Liability
The deferred taxes in a 1031 exchange are typically smaller than those you’d pay in a standard transaction, says the IRS. However, if the property performed beautifully under your ownership, you may owe quite a bit on that gain.
Ask your financial team to run the numbers for you. How much will you owe if you sell the property outright? How much would you save if you exchanged it again? How much would you save if you held onto the property for a little longer?
Your Real Estate Market
Fluctuations in the market could influence your decisions. For example, in June of 2024, office vacancies remained at a record high of 14%. If you have real estate holdings in this market, selling your assets outright could be a wise move to stem the losses. However, if you know a big company is coming to your community, you may choose to keep your investment or expand it.
Ask your acquisitions team or real estate professional to run scenarios for you. Which assets in your portfolio are likely to perform, and which are better to cut? If you sell in a low market, how much could you lose in potential profits?
Your Financial Health
Some investors want to focus on other priorities and need to cash out. For example, you may face unexpected health expenses. You may need to fund a child’s wedding or college education. Or you may just want to do something different with your money. Ultimately, how you treat your investments is personal, and your path might not follow a predictable route. Only you know what’s right for your financial health right now.
Consider Another 1031 Exchange
Selling a 1031 exchange property outright could cost you. Consider reinvesting via another transaction.
At 1031 Pros, we specialize in these complicated deals. We can work as your qualified intermediary and hold funds while you look for the perfect opportunity. We can also run the pros and cons of a sale with you, allowing for a smart decision about your future. Contact us to start the conversation.
References
The Truth About 1031s. (March 2021). National Association of Realtors.
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
June 2024 Commercial Real Estate Market Insights. National Association of Realtors.