What Can You Buy With a 1031 Exchange?

A 1031 exchange is an investment and tax tactic that gets its name from Section 1031 of the Internal Revenue Code. The execution of a 1031 exchange may allow a taxpayer to defer recognition of capital gains taxes when they sell an investment property and reinvest the proceeds into another asset. The rules are strict in some ways, such as the timeline, but generous in others, such as regarding what properties the taxpayer can exchange.

How does a 1031 exchange work?

If an investor judiciously follows the rules, using a 1031 exchange can allow them to defer the payment of capital gains taxes when they sell an investment property and reinvest the proceeds in “like-kind” property. The definition of ‘Like-kind” is one of the aspects of the code which the IRS generously interpreted. The IRS typically allows any commercial property to be exchanged for any other. So, for example, an investor could sell a multifamily housing complex and reinvest in self-storage facilities. Similarly, the investor can sell raw land and buy an office building. What they may not do is exchange a primary residence for an investment asset.

Furthermore, only real estate assets are eligible for 1031 exchanges. Therefore, investors may not defer other gains (such as from selling stocks, collectibles, or other items) using this method. Nonetheless, using a 1031 exchange can be very helpful for an investor seeking to shift from active management to passive investment or to change their sector emphasis or geographic footprint.

What are the requirements for investors?

Successful execution of a 1031 exchange requires adherence to several significant rules. First, there is a tight timeline. Once the investor sells the original property (usually called the relinquished asset), they have 45 days to formally identify potential replacement properties. A formal identification involves notifying their Qualified Intermediary, who oversees the transaction and maintains a separate account for the proceeds. The potential replacement properties must satisfy one of these options:

1. The three-property rule allows the investor to identify up to three potential targets with no limit on combined value. The investor can purchase any one or a combination of these.
2. The 200% rule allows an investor to identify an unlimited number of potential property acquisitions as long as the combined value does not exceed 200% of the sale price for the relinquished asset. If the investor seeks to spread out their assets with smaller value properties, this will allow them to downsize the individual units.
3. The 95% rule lets the investor identify any number of properties with the stipulation that they must acquire a combination that equals at least 95 percent of the combined value. However, this option is less frequently used and may decrease the likelihood of success.

Note that no matter which identification option the investor uses, they must at least replace the value and debt level of the relinquished property.

Following the identification process, the investor must complete their transaction within 180 days (including the 45 established for identification) to defer the tax payment. The Qualified Intermediary maintains transaction documentation and transfers the funds from the separate escrow account to the sellers. The taxpayer mustn't be able to access the funds during the transaction period.

While a 1031 exchange only defers rather than eliminates the obligation to pay capital gains taxes, the tactic can be used sequentially. For example, if the investor conducts a 1031 exchange and then later transacts a sale without employing the exchange, they will owe the deferred taxes. However, they can continue using the exchange to swap properties repeatedly. When the investor ultimately bequeaths the last property to an heir, the heir receives that property at the stepped-up value, and previous deferrals are eliminated.