What is a 1031 exchange?

Postponing the tax

When you sell an investment property at a profit, you normally owe capital gains tax. A 1031 exchange lets you postpone that tax by putting the proceeds into another investment property.

The rule comes from Section 1031 of the Internal Revenue Code. It says no gain or loss is recognized when you exchange real property held for business or investment use for real property of like kind, provided the new property is also held for business or investment.

Like-kind exchanges have been part of the tax code since 1921, over 100 years. The DST comes from Delaware law, and IRS Revenue Ruling 2004-86 allowed a DST interest to be used as replacement property in a 1031 exchange.

Like-kind covers business and investment real property. Property held solely for personal use, such as a primary residence, generally does not qualify. The tax is deferred, not forgiven.

Why investors use a 1031 exchange

Investors use 1031 exchanges for several reasons. A properly executed exchange may defer federal and state taxes, allowing more equity to remain invested in replacement real estate rather than being used to pay current tax.

Replacement property may also provide additional depreciation, improve cash flow, diversify real estate holdings across properties and markets, or allow an investor to step away from day-to-day property management while continuing to own investment real estate.

These are potential benefits, not assurances.
See our risk disclosures.

The 45-day and 180-day deadlines

In a 1031 exchange, you generally cannot receive or control the sale proceeds yourself. A qualified intermediary holds the funds during the exchange process. You then have 45 days to identify your replacement property and 180 days to complete the exchange. Both periods are counted from the day after your sale closes and run at the same time, so the 180 days is not an extension of the 45.

If your tax return for that year is due before day 180, your exchange ends on that earlier date, unless you file an extension. Miss a deadline and the exchange generally fails and the gain becomes taxable, though deadlines can be postponed in federally declared disaster areas.

Check your dates with the Deadline Calculator. The same page checks your property list against the 3-property, 200% and 95% rules.

Matching equity, debt and value

To fully defer taxes in a 1031 exchange, you must reinvest an equal or greater amount of equity and replace the debt associated with the relinquished property. However, the debt does not have to be replaced with debt. If the replacement property has less debt, you can make up the difference by investing additional equity.

For example: If you sell a property for $1,000,000 with $500,000 of debt and $500,000 of equity, and your replacement property has $400,000 of debt, you can invest an additional $100,000 of equity to make up for the reduction in debt. Your replacement property would then have $400,000 of debt and $600,000 of equity, for a total value of $1,000,000.

Your 1031 LTV comes from the closing figures on the property you’re selling — the equity and the loan payoff — not what you originally put down or borrowed. Run your own numbers with the Property Sale Calculator.

A Delaware Statutory Trust (DST) can provide additional flexibility because you can invest in one or multiple DSTs with different levels of debt, allowing you to structure your replacement investments around the equity and debt requirements of your relinquished property. Model the exchange with the DST Replacement Calculator.