What Is a 1031 Exchange & Is It a Good Idea?

Updated: Oct 31

What is a 1031 exchange? It’s a method for real estate investors to swap one property for another and save money on taxes.

A 1031 exchange gets its name from the tax code. Under Section 1031, the IRS defines an in-kind exchange as trading one property used for business or held as an investment for another similar property. These types of swaps have been legal for decades, but the rules are complex. Typically, investors need help to complete these transactions legally.

Is a 1031 exchange a good idea? It depends. In a 2023 Gallup poll, 34% of Americans said real estate is their top investment selection. If you’re one of them, you want to make the most of the money you put in, and you want to get the most back out.

A 1031 exchange can help to reduce your tax burden, and it might prompt you to diversify your portfolio and reduce your risks. However, it can tie up your investments for long periods, and it’s not a smart strategy if you need cash right away.

Keep reading to find out more about how 1031 exchanges work, who they’re right for, and how to get help with one.

What Is a 1031 Exchange?

A 1031 exchange is a straightforward real estate investment swap. An investor sells a property and uses the proceeds to purchase a similar property. After the transaction, the investor can defer any capital gains that would traditionally apply.

What Is a Like-Kind Property?

The IRS explains that both the sale and the purchase must be “mutually dependent parts of an integrated transaction constituting an exchange of property.” In other words, you can’t sell one property, find another one years later, and expect to use this process. Everything must be tied together.

Similarly, the two properties must be “like-kind.” This means both properties must be in the United States. For example, you can’t sell an investment property in Mexico and use it to purchase another property in the United States. The property you buy must be at least as valuable as the old one and have a similar amount of depreciation potential (such as buildings or improvements).

Most real estate properties are classified as like-kind, and some people are surprised by how liberal that definition can be. For example, you may be able to exchange an apartment building for a retail building, or you could potentially swap a farm for vacant land if the value is similar. Since the specifics can get a bit confusing, it pays to have an expert ensure that your potential swap fits within IRS rules.

What Are the Types of 1031 Exchanges?

There are a few main types of 1031 exchanges.

Delayed exchange: This is the most common type of 1031 exchange. Investors need to purchase a replacement property within 180 days of relinquishing the prior property. They have 45 days to identify a new property. A qualified intermediary holds the funds from the sale until they are released to acquire the new property.
Simultaneous exchange: In this type of exchange, the old property and the replacement property both close on the same day. Because so many logistics are involved in sales, it can be tough to time this perfectly. As a result, simultaneous exchanges aren’t common.
Reverse exchange: This is when the new property is acquired before the original property is sold. In this case, the qualified intermediary will hold the property until the prior property is sold and funds can be released to purchase the new property. The investor cannot own both properties at the same time, or the 1031 will be void.
Construction or improvement exchange: This 1031 exchange involves an investor building or improving a property to fit their needs, using the equity they’ve generated from the exchange. Any construction or improvements must be completed within 180 days of the sale.

What Is an Intermediary?

Most investors use an intermediary or exchange facilitator, the IRS explains. These professionals hold onto the proceeds from one sale and use them to make the secondary transaction. Their work helps the investor to avoid the tax consequences of accepting sale proceeds too early.

If you have a delayed 1031 exchange, which most 1031 exchanges are, you need to put your funds with that third party. They’ll hold them in escrow until the new property is acquired.

What Are Typical Time Frames?

A 1031 exchange comes with tight time frames.

After the sale of the initial property, the investor must pinpoint possible substitute properties within 45 days. This identification must be in writing and delivered to the seller of the property and your intermediary.

The sale of that replacement property must be complete no later than 180 days after the sale of the first property or the income tax return for the tax year in which the original property was sold, whichever is earlier.

Since these time frames are tight, most people plan ahead for a 1031 exchange, aiming to identify potential properties before they begin the process of selling the old property. This ensures they can move quickly on the final identification process and fit it in within the specified time frame. It’s a good idea to identify a few potential properties early on and nail down the decision when you get close to the original property’s sale.

Benefits of a 1031 Exchange

About 4 adults in 10 say they’re bothered by the amount they pay in taxes. Almost all Americans want to reduce the amount they give to the tax collector every year. Saving on taxes is a key benefit of a 1031 exchange.

As a real estate investor, you slowly deduct the wear and tear (depreciation) from your properties in your taxes every year. When you sell that property, the IRS collects some of those deductions back in a process called depreciation recapture. A 1031 exchange allows you to avoid this recapture tax.

A 1031 exchange could also encourage you to exchange very similar properties for something slightly different, so you can diversify your portfolio and reduce your risk.

Consider the 2024 storms that hit Texas. In Polk County, the Trinity River was 12 feet above flood stage. If you owned two or three buildings along this river, your damages could have been extensive.

By using a 1031 exchange, you could diversify your investments by type, location, or both. You could also reinvest in a property that has a higher return on investment.

There isn’t a limit on how many 1031 exchanges you can do. Many people repeatedly do 1031 exchanges. They use a 1031 exchange to sell one property and acquire another; then, they might repeat that process a few years later. It’s so common that 1031 exchange is often used as a verb. For example, “Did you 1031 exchange the property?”

Drawbacks & Considerations of a 1031 Exchange

Tight time frames mean you must sell your property, pick a new one, and wrap up the transaction quickly. If you’re the type of investor who likes to carefully weigh options before making a move, an exchange could be less than ideal.

You may even have a new property identified, but then, things fall apart in the buying process. You don’t get an extended timeline when this happens. You’ll have to quickly identify a last-minute replacement, and this might mean that you acquire a property that is less desirable and doesn’t fit your needs.

You’ll also face fees during this process. Your qualified intermediary will charge fees, and you may face costs due to appraisals, repairs, and other real estate issues. It’s a good idea to factor all these costs into the planning process before you get started, so you’ll have a clear idea of the total bill you’ll be facing.

A 1031 exchange also keeps your money tied up in real estate investments. If you’re hoping to sell to put some money back in your pocket, this could be a major drawback. It requires some future foresight to determine if it’s a good investment step for you.

Is a 1031 Exchange Right for You?

Consider your investment portfolio and risk tolerance. If you’ve been looking for a way to diversify or trade assets, a 1031 exchange could be a smart strategy that helps you achieve your goals with a small tax burden.

If you’re not sure or you need more information to make a smart decision, contact us. At 1031 Pros, we handle exchanges in all 50 states. With over 30 years of combined exchange experience, we’re qualified and ready to help. We make the process easy and can answer all your questions along the way. Contact us to get started today.