Do You Have to Reinvest Everything in a 1031 Exchange?

A 1031 exchange refers to a section of the Internal Revenue Code allowing investors to defer the capital gains taxes when they sell an investment asset if they reinvest the proceeds from the sale. Using the tool, investors can sell a real estate investment property that has appreciated without paying capital gains or depreciation recapture if they reinvest the proceeds in a “like-kind” asset.

The IRS has defined “like-kind” as any other investment property. For example, the taxpayer can sell multifamily housing to buy an office building or exchange vacant land for retail property. The exchange can include any sector, class, or geographic area. In fact, one notable opportunity when performing a 1031 exchange is the ability to enter or exit a Delaware Statutory Trust (DST). The eligibility of DST participation can rescue an investor trying to meet the IRS’ tight deadlines for completing a 1031 exchange.

How does a 1031 exchange defer taxes?

Not surprisingly, the IRS closely regulates how 1031 exchanges are conducted since the benefit available can be substantial. Suppose an investor owns an apartment complex for which they paid $500,000 but is now valued at $2 million. If the owner wants to redirect their portfolio to another sector, like industrial facilities, they will owe capital gains taxes on the $1.5 million appreciation.

Even with capital gains rates being lower than the tax on ordinary income, that levy can dampen their ability to reinvest. If the investor executes a 1031 exchange to sell the targeted relinquished property and replace it with another property, they can leverage their buying power by deferring as much as $300,000.

What are the rules?

First, the exchange must be completed following a restrictive timeline. The investor has 45 days following the initial sale to formally identify potential replacement properties. They have several options for the identification protocol concerning the number of properties identified. Still, ultimately the investor must buy property with the same or higher value than the original asset.

So, in the example provided, the investor will need to buy one or more properties with a total value of at least $2 million. The code section also requires that the debt level be matched or exceeded, so if the investor had a mortgage on the original property of $400,000, the replacement must also have at least that much mortgage debt.

Following the 45-day identification period (identification is a formal process in which the investor identifies potential purchases by notifying the Qualified Intermediary (QI) handling the exchange), they must complete the transaction to acquire the replacement asset(s) within 135 additional days. The entire process is limited to 180 days. Furthermore, the taxpayer must report the exchange in the year completed. The investor will need a filing extension if the completion straddles two tax years.

What if I only want to reinvest a portion of the proceeds?

Sometimes, an investor might want to reinvest part of their proceeds into replacement property, using the balance for other purposes. However, a 1031 exchange does not allow that. Any amount of the sales price not reinvested is a taxable boot, and the capital gains taxes will be due. In addition, if the investor later sells the replacement property without completing another 1031 exchange, they will owe both the deferred taxes from the first transaction plus taxes due on any appreciation accrued to the replacement. However, an investor can continue using the 1031 exchange to defer the taxes that accrue with each new sale and purchase combination. Ultimately, if they bequeath the final asset to an heir, the heir will receive the property at the stepped-up value, and previously deferred taxes will be eliminated.