1031 Exchange Deep Dive

A 1031 exchange (named after IRC Section 1031) allows you to sell an investment property and defer all capital gains taxes by reinvesting the proceeds into a "like-kind" replacement property. It's one of the most powerful wealth-building tools in real estate.

Why It Matters: - Federal capital gains tax: 15-20% on long-term gains - Depreciation recapture: 25% tax rate - State capital gains: 0-13% depending on state - Net Investment Income Tax: 3.8% for high earners

On a $200,000 gain, you could owe $50,000-80,000 in taxes. A 1031 exchange defers all of it.

The Power of Compounding: Instead of paying taxes and reinvesting the remainder, you reinvest the full amount. Over multiple exchanges, the compounding effect is enormous. An investor who 1031s consistently will accumulate 30-50% more wealth over 20 years compared to selling and paying taxes each time.

Strict Requirements: - Both properties must be held for investment or business use (not personal) - Must be "like-kind" — any real estate for any real estate (a single-family home can be exchanged for an apartment building) - Cannot exchange into a property in a different country - Must use a Qualified Intermediary (QI) to hold proceeds

Critical Deadlines: - Day 0: Close on the sale of your relinquished property - Day 45: Identify up to 3 replacement properties (or more under special rules) - Day 180: Close on the replacement property

Missing either deadline kills the exchange entirely.

Identification Rules: - 3-Property Rule: Identify up to 3 properties of any value - 200% Rule: Identify any number of properties as long as total value doesn't exceed 200% of what you sold - 95% Rule: Identify any number at any value, but must close on 95% of what you identify

Most investors use the 3-Property Rule for simplicity.

To defer 100% of taxes, the replacement property must meet these tests:

Equal or Greater Value: - Replacement purchase price >= relinquished sale price - Example: Sell for $500,000, must buy for $500,000+

Equal or Greater Debt: - Mortgage on replacement >= mortgage on relinquished - Or make up the difference with cash

All Equity Reinvested: - Every dollar of equity from the sale goes into the replacement - Keeping any cash triggers "boot" and partial taxation

What is Boot? Boot is any value received that doesn't qualify for deferral: - Cash kept from the sale - Reduction in debt (mortgage boot) - Personal property received in the exchange

Boot is taxed as capital gain. Avoid it by ensuring equal or greater value and debt.

Reverse Exchange: Buy the replacement property first, then sell the relinquished property. Useful in competitive markets where you need to secure the replacement before your sale closes. More complex and expensive, but effective.

Improvement Exchange (Build-to-Suit): Use exchange proceeds to improve the replacement property. The QI holds the property in an Exchange Accommodation Titleholder (EAT) while improvements are made. Must be completed within the 180-day window.

Drop and Swap: If you own property in a partnership, "drop" your share into individual ownership, then exchange individually. Requires planning — the IRS wants to see genuine investment intent.

Serial 1031s: Exchange repeatedly over your lifetime. Each exchange defers the cumulative gains from all previous exchanges. At death, heirs receive a stepped-up basis, potentially eliminating all deferred taxes permanently.

1031 into DST (Delaware Statutory Trust): For investors who want to go passive, DSTs are pre-packaged institutional real estate investments that qualify as replacement properties. Invest $100,000+ into a professionally managed portfolio without landlord responsibilities.

Mistake 1: Not engaging a QI before closing You MUST have a Qualified Intermediary in place before your sale closes. You cannot touch the proceeds — not even for a moment.

Mistake 2: Missing the 45-day identification deadline Set calendar reminders. This deadline is absolute — no extensions, no exceptions, even for holidays or weekends.

Mistake 3: Not accounting for mortgage boot If your old property had a $300,000 mortgage and your new one has a $250,000 mortgage, the $50,000 difference is taxable boot.

Mistake 4: Using the property personally The IRS requires investment intent. If you exchange into a vacation home and use it personally, you risk disqualification. The safe harbor is: rent it for 14+ days/year and limit personal use to 14 days or 10% of rental days.

Mistake 5: Exchanging into a bad deal Don't let the tax tail wag the investment dog. A 1031 exchange into a poor investment costs more than paying taxes and buying wisely. Run full analysis on replacement properties — Investra can help you evaluate opportunities quickly under tight deadlines.

Your Exchange Team: - Qualified Intermediary: Holds proceeds, prepares documents. Cost: $750-1,500 - CPA/Tax Advisor: Ensures compliance and optimal tax strategy - Real Estate Attorney: Reviews contracts, ensures exchange language is included - Real Estate Agent: Helps find replacement properties within the timeline

Choosing a QI: - Must be independent (not your agent, attorney, or CPA) - Check for fidelity bond and errors & omissions insurance - Verify they use segregated, insured accounts for exchange funds - Ask about their track record and references

Costs of a 1031 Exchange: - QI fees: $750-1,500 - Legal review: $500-1,000 - Additional closing costs on replacement - Potentially higher purchase price due to time pressure

Is It Worth It? Almost always, yes. Even with exchange costs of $2,000-3,000, deferring $50,000+ in taxes makes the math overwhelmingly favorable.