If you have an investment property and are looking for a replacement for better returns, the 1031 tax-deferred exchange may be worth considering. The 1031 exchange is a powerful tool that most savvy real estate investors use to grow their portfolios and build more wealth.
In this article, you will learn more about this tax-deferment strategy to know whether it is worth applying in your real estate investing.
Table of Contents
What is a 1031 Exchange?
A 1031 exchange lets you sell your business property or investment and buy a similar property with the deferment of the capital gain taxes. Also known as Like-Kind Exchanges, a 1031 tax-deferred exchange is defined in section 1031 of the Internal Revenue Code.
It is an excellent strategy for anyone who wants to build wealth from their investment and save on taxes usually set upon the sale.
This exchange requires that proceeds from the property under sale be reinvested in another property of equal or greater value within specified time limits. Also, it is essential to note that the 1031 exchange is only a deferment of the taxes and not a reduction or credit. While the investor will not pay the taxes on capital gains during the sale, he will still pay them in due course.
What are the Eligibility Requirements?

Eligibility Requirements 1031 Exchange
Any property held for productive use in business, trade, or investment can qualify for a 1031 exchange. Such properties could include a commercial building, an apartment, a vacant lot, or even a single-family residence.
However, there are exceptions for this exchange.
For instance, primary residences like your home or vacation house may not be eligible for 1031 tax-deferral since they are generally not used for trade or business. Nevertheless, a vacation house may qualify for exchange given that the taxpayer had limited use of the property.
Also, properties that involve bonds, securities, notes, stocks, and interests in partnerships are excluded from this treatment. Any property held mainly for sale, such as business inventory, is also disqualified from the 1031 exchange. This is also true for a real estate property that is purchased for selling.
Benefits of a 1031 Exchange
If you are a real estate investor, there are many reasons for considering a 1031 exchange. The benefits include the following:
- Defer capital gain taxes on the sale of property
- Ability to switch types of property
- Allows for diversification of a real estate portfolio
- Increases the purchasing power
- Gives entry into diverse real estate markets
- Increases appreciation potential
What are the 1031 Exchange Rules and Regulations?
A 1031 exchange can only occur as long as it adheres to the U.S. Internal Revenue Code rules and regulations which are as follows:
1. Like-Kind Property
The property being purchased, and the property being sold must be like-kind or similar.
2. Business or Investment Property
Capital gains tax can only be deferred for business or investment property and not personal property.
3. Equal or Greater Value Replacement Property Rule
Real estate investors can execute the 1031 exchange when they buy a replacement property of equal or greater value to the one being sold.
4. Same Tax Payer
The IRS requires that the tax return and titleholder of the property being sold be the same as the titleholder and tax return of the purchased property.
5. Must Be Boot-Free
For a 1031 tax-deferred exchange to occur, the property being acquired must not be of a lower value. Otherwise, the difference between the two properties, called boot, is subject to tax based on the gains received during the partial 1031 exchange.
6. 45-Day Identification Window
Another rule of the 1031 exchange is that the property owner must identify the replacement property within 45 days. He must identify at least three properties of equal or greater value within the set time.
7. 180-Day Purchase Window
The IRS allows a 180-day window after the first property sale to close the purchase of the replacement property. You should note that the 180-day time frame does not equal six months since each day, including holidays and weekends, is accounted for.
Types of 1031 Tax-Deferred Exchanges

If you wish to undertake a 1031 exchange, there are 4 common ways to complete it. They include:
1. Delayed Exchange
The delayed exchange is the most popular type of 1031 exchange that investors can make. It involves selling or relinquishing your investment property and purchasing a replacement property within the specified time frame.
2. Simultaneous Exchange
This type of 1031 tax-deferred exchange involves buying the first property and selling the replacement property on the same day. It is a simultaneous exchange that must coincide; otherwise, the exchange will not be eligible.
3. Reverse Exchange
In a reverse exchange, the investor must first identify a suitable property before relinquishing the current property. This means that you can purchase a new property and wait for the relinquished property market value to increase before selling it within the remaining 135 days. Also, you should note that this type of exchange requires 100% cash.
4. Improvement or Construction Exchange
This is a less common type of 1031 exchange that occurs when the investor makes improvements to the replacement property before possession. Here, you will relinquish your current property and identify a replacement property, which will be under a qualified intermediary for 180 days. The improvements can be made using the proceeds from the sold property.
Things to Note:
During the exchange, the investor can’t get proceeds from the sale of the relinquished property if the replacement property is not purchased. Instead, the funds are held by an exchange intermediary or accommodator in escrow until the replacement property is identified and purchased.
Conclusion
As an investor, a tax-deferred 1031 exchange may be helpful if you want to reinvest the proceeds of your investment property into like-kind assets while deferring capital gains tax. Using this strategy, you can easily purchase properties with better returns or diversify your investments with different assets.
We hope this article has helped you learn more about the 1031 exchanges, the rules involved, and the available types. Whatever type of 1031 exchange you choose, it is recommendable to hire a qualified exchange intermediary to help with your exchange.
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