If you haven’t noticed, there really hasn’t been a better time to sell a property.
Add in the fact that sellers are receiving multiple offers within a few days after listing and you have all the right ingredients to start a bidding war, increase the price of your property, and walk away with more than you could imagine.
But, there is an issue. Taxes.
It’s great seeing the price tag of your property increase, but that also means your tax bill will be significantly higher. If you want to take advantage of the appreciation your current investment has earned but don’t want to get hit with the corresponding tax bill; you might want to consider some of these 1031 exchange strategies the top investors are using to navigate the seller’s market.
Why use a 1031 exchange?
How a 1031 exchange works is that with a 1031 exchange, you can shelter your gains from being taxed by following up the sale with another real estate investment of equal or greater value. If you follow the rules set by the IRS, your real estate investments can grow tax-deferred.
The challenge of using a 1031 exchange in a seller’s market
These days, the most challenging part of executing a 1031 exchange is finding the replacement property within 45 days of closing the sale on the former property.
As we discussed earlier, sellers are enjoying the luxury of bidding wars and sky-high prices. Investing in today’s market is much more challenging. Deals are hard to find, and you can’t guarantee that the property you want will fall into your hands.
The good news is that once found and placed under contract, the IRS grants an additional 135 days to finalize the purchase before the 1031 exchange is no longer eligible.
1031 exchange strategies
The best way to execute these 1031 exchange strategies is to have a plan before the property you’re selling is placed under contract. It’s the time of closing that determines 1031 exchange eligibility, so you’ll need to know your available routes before this date.
You don’t need to have the ball rolling on a second property while your current is under contract. Not everyone is comfortable going after the replacement property before their original sale closes—even with contingencies. Make sure to determine your risk tolerance and only take action that lets you sleep at night.
The four 1031 exchange strategies we’re going to talk about are based on where you’re currently at in the sales timeline. Those are:
- If you haven’t listed your property yet
- If you’re already under contract
- If you’ve already closed
- Use a reverse exchange
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If you haven’t listed your property yet
The first strategy is to negotiate the closing of your sale in a way that keeps you in the driver’s seat. If you can find a friendly buyer, this is the simplest way to do a 1031 exchange.
A buyer willing to wait for you to conclude your property search is the best-case scenario, but if you can’t find someone willing to wait, you need to research a few things.
First, find data on your market and examine the average days on market (DOM). This number will let you know how long you have to find another property or even the leverage you have over selling your own.
You can source this data through Zillow, Redfin, or Realtor.com. Or, get in touch with a trusted local real estate agent in your area who can provide highly accurate data using the multiple listing service (MLS).
You could also ask other real estate investors what their past month has looked like in your area.
Based on what you find out, here are the following options you have:
- Delaying putting your property on the market until after you find a replacement.
- Negotiate an extended sale date with the option to accelerate.
- Add a contingency clause to the offer that makes the sale dependent on you finding a suitable replacement within a certain amount of time.
- Add the option to extend closing by 15-30 days or more.
If you’re already under contract
If you are already under contract to sell your property, you can still take action to meet your 45-day identification deadline.
The goal is to begin making offers as soon as possible. The difficulty in a seller’s market is that buyers have little to no leverage. If you can’t meet the seller’s terms, they can simply choose another offer. So you’ll have to be smart.
You have a few paths to take here:
- Consider making offers contingent on your sale (the odds of this working is extremely low in a seller’s market, but it’s worth trying on a couple of properties).
- Ask for an extended closing (I suggest two weeks after your sale is scheduled. Some of our investors are experiencing lender delays on their sales that disrupt tight closings).
- Try to get an inspection, due diligence, or financing clause that expires a week or two after your sale is scheduled to close.
- Consider a tiered earnest money offer to get one of the above strategies to work. Specifically, offer a solid earnest money deposit at signing with another larger earnest money deposit after your sale closes. Make these refundable or non-refundable depending on your risk tolerance and what the situation warrants.
If you’ve already closed the sale
This isn’t the best scenario to be in, but not all hope is lost. Remember, you still have 45 days post-closing to find a replacement property to execute a 1031 exchange.
But, you need to be fast and efficient in looking for new properties.
If you’ve exhausted your options and spoken to every connection you have who might know about a new deal coming to market, from the local agent to the plumber who always fixes the leaky faucets, you might want to consider expanding your range.
The first thing is to consider dipping into markets outside of your own. If you haven’t been already, you might also want to look at properties that you might not normally invest in.
For instance, if you’re a short-term rental investor but can’t snag a deal, perhaps you should dip into the multifamily market?
Finally, maybe it’s time to look into fractional property ownership structures like a Delaware Statutory Trust or a syndicated tenant in common project. When done right, these types of investments can prove to be lucrative and provide a 1031 exchange outlet.
Use a reverse exchange
If you have found the perfect replacement property but can’t get the sale of your original property lined up in advance, a “reverse” exchange may be a good fit.
A reverse exchange is a more complex exchange structure with a longer lead time, special financing requirements, and a higher price tag. That being said, if you locate a great opportunity, the exchange will defer a significant amount of tax.
A reverse exchange makes sense in a seller’s market as hot as the one we’re in now if you can pull it off.
While certainly not the preferred option, it is important to emphasize that there is no penalty for starting a 1031 exchange and not completing it.
If you cannot find a suitable replacement, it would be better to let your exchange die and pay the taxes rather than make a bad investment. In the long run, you’ll regret the bad investment more.
If you have any other 1031 exchange strategies, leave a comment below to share them with the BiggerPockets community!
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
- Simultaneous 1031 Exchange. A simultaneous exchange happens when you relinquish property and acquire the replacement property at the same time. ...
- Delayed 1031 Exchange. This 1031 real estate exchange program is the most common. ...
- Reverse 1031 Exchange. ...
- Improvement Exchange.
How Does A 1031 Exchange Work? As a seller, you can postpone capital gains taxes by selling a property and putting the proceeds toward a like-kind property, or property similar in nature and value. If you don't receive any proceeds from the sale, there's no income to tax.What is the 1031 exchange strategy? ›
A 1031 exchange is a tax strategy that allows investors to sell an investment property in exchange for another property, then defer capital gains from the first property's sale. This strategy is advantageous for investors who wish to purchase more real estate rather than cash out.What is the new 1031 exchange option for sellers of investment properties? ›
A 1031 Exchange allows Landlords to sell their investment property without the tax liability and better position themselves to achieve financial and lifestyle objectives on the reinvestment.What are the different types of boot in 1031 exchange? ›
The term boot refers to non-like-kind property received in an exchange. Usually, boot is in the form of cash, an installment note, debt relief or personal property and is valued to be the “fair market value” of the non-like-kind property received.What is the 5 year rule for 1031 exchanges? ›
If a property has been acquired through a 1031 Exchange and is later converted into a primary residence, it is necessary to hold the property for no less than five years or the sale will be fully taxable.What invalidates a 1031 exchange? ›
A 1031 exchange must be completed within a 180-day period. This starts from the date of the sale of the relinquished property. If the exchange isn't completed within that time frame, it's considered invalid.What is the 45 day rule for 1031 exchanges? ›
The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary.Can you do a 1031 exchange after you sell? ›
As a general rule, an investor can rescind their sale transaction as long as it occurs in the same tax period in which the property is sold. Doing so would allow them to re-do the sale and complete a 1031 Exchange the second time around.What is the most common 1031? ›
Delayed exchanges are the most common form of 1031 exchanges. Exchangers have 45 days to identify a like-kind replacement property and must close on the property within 180 days.
- 1031 Exchanges. ...
- 5 Ways to Build Wealth With a 1031 Exchange DST. ...
- Defer Capital Gains Tax to Maximize ROI Equity. ...
- Build Wealth by Increasing Buying Power. ...
- Diversify Holdings to Reduce Risk. ...
- Consider New Investment Strategies. ...
- Build Generational Wealth by Eliminating Tax for Beneficiaries.
- Sign Exchange Documents Before You Close. ...
- Think About Who Will Acquire Replacement Property. ...
- Buy Enough Replacement Property to Defer All of the Gain. ...
- Think About Expenses. ...
- Think About Experience and Safety.
- IPX1031: Best Overall 1031 Exchange Company.
- Exeter 1031 Exchange Services, LLC: Best 1031 Exchange Company for Complicated Exchange Types.
- First American Exchange Company: Best 1031 Exchange Company for Online Services.
Commercial property including rental properties, condominiums, shopping centers, strip malls, timberland, gas and water interests, and land represent real property eligible for a 1031 exchange. One of the popular examples of 1031 Exchange replacement properties include Delaware Statutory Trusts or DST properties.What is the 2 year rule for 1031 exchanges? ›
The taxpayer and the related party must hold the properties that each received as part of the 1031 Exchange transaction for a minimum of two (2) years. The two (2) year holding period starts running on the date of the transfer or conveyance of the last property involved in the 1031 Exchange related party transaction.How do I avoid capital gains tax on a 1031 exchange? ›
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.What happens if you don t use all the money in a 1031 exchange? ›
One of the most important is that real estate investors must reinvest all of their sales proceeds into the new property. If they don't, the portion not invested is known as “boot” and that part of the gain is taxable.What are the boot methods? ›
There are two types of the boot: Cold Boot/Hard Boot. Warm Boot/Soft Boot.What is the 95% rule in 1031 exchange? ›
The 95% rule says that a taxpayer can identify more than three properties with a total value that is more than 200% of the value of the relinquished property, but only if the taxpayer acquires at least 95% of the value of the properties that he identifies.
Thanks to a recent Disaster Notice issued by the IRS, affected taxpayers like you now have until October 16, 2023 to BOTH Identify and Close on a new “replacement” property for a 1031-Exchange. This is a once in a lifetime chance to take advantage of the government's offer as a real estate investor.
DST Returns On Investment - What Could You Expect? Typical DST Returns on a 1031 exchange investment could yield between 5%- 8% of monthly distributions based on your fractional interest.What would disqualify a property from being used in a 1031 exchange? ›
Under IRC §1031, the following properties do not qualify for tax-deferred exchange treatment: Stock in trade or other property held primarily for sale (i.e. property held by a developer, “flipper” or other dealer) Securities or other evidences of indebtedness or interest. Stocks, bonds, or notes.Can I buy my parents house in a 1031 exchange? ›
Yes. But the family member cannot sell the property for two years; otherwise their transaction will trigger the tax you have deferred. The IRS is looking for what is called related party transactions on Form 8824 used to file the 1031 exchange with your yearly Form 1040.Can you flip a house with a 1031 exchange? ›
As such, when it comes to real estate flipping and 1031 exchanges, these two activities are incompatible. They have different investment purposes, adhere to different processes, and generally follow different hold periods.How long can money sit in a 1031 exchange? ›
This 180 day period is the maximum time that the funds can be retained in the escrow account that the qualified intermediary has established for the exchange.How many times can you do a 1031 exchange in a year? ›
There is no restriction on the number of times you can participate in a 1031 exchange. As long as you meet all the requirements and have an experienced intermediary by your side, you can use this tool as often as possible to minimize your capital gains taxes.How long after 1031 exchange can you live in? ›
Your personal use of the property, including occupancy, must not exceed either 14 days or 10% of the total number of days you rented out the property within 12 months. This exchange only applies to single-owner properties. Once the 24 months conclude, you can move into the property and declare it a primary residence.Can I sell two properties and buy one in a 1031 exchange? ›
SELLING MULTIPLE PROPERTIES IN AN SECTION 1031
When performing a Section 1031 tax-deferred exchange, an exchanger may sell multiple relinquished properties in a single exchange, exchanging several properties into one (or multiple) replacement properties.
The properties being exchanged must be considered like-kind in the eyes of the IRS for capital gains taxes to be deferred. If used correctly, there is no limit on how frequently you can do 1031 exchanges.Do I have to reinvest all proceeds in a 1031 exchange? ›
In a standard 1031 exchange, you need to reinvest 100% of the proceeds from the sale of your relinquished property to defer all capital gains taxes. In a partial 1031 exchange, you can decide to keep a portion of the proceeds. This boot amount is taxable, while the money you reinvest is not.
Some of the risks of 1031 exchange DST properties may include the fact that there are no guarantees for monthly distribution amounts, no guarantees for projected appreciation, illiquidity, loss of day-to-day management control, interest rate risk and potential loss of entire principal amount invested.What happens if you don t identify a property within 45 days on a 1031 exchange? ›
If you do not identify or acquire the replacement property within the 45 days, you are not able to complete a valid exchange. In addition to making sure you identify replacement property within 45 days, you must identify it unambiguously. That generally means using a legal description or street address.How many properties can you list on a 1031 exchange? ›
Most investors swap two properties via a 1031 exchange – an old property is sold and replacement property is purchased. However, you can identify up to three properties in a 1031 exchange. Once you identify the three properties you intend to sell, you can identify up to three replacement properties.Do improvements count in a 1031? ›
1031 Exchange requirements must be applied in the Improvement Exchange. This requirement means that all improvements must be constructed within the 180-day time period.What is the difference between a tic and a DST 1031 exchange? ›
DSTs differ from Tenancy in Commons (TICs), another 1031 Exchange fractional ownership strategy, in that each investor does not own a fractional, undivided interest in a property as a co-owner. Therefore, DST investors are not required to share the associated costs of ownership, or be considered “tenants in common.”What are the different types of like-kind exchanges? ›
There are four main types of like-kind exchanges that real estate investors can choose to execute. The types of 1031 exchanges are simultaneous exchange, delayed exchange, reverse exchange, and construction or improvement exchange.Does a 1031 exchange have to be the same type of property? ›
The property that you obtain must be a “like-kind property” in order for the transaction to be considered a 1031 exchange. However, this is a broad term, which means that the property you obtain doesn't need to be exactly the same as the one that you relinquished.What is the difference between 1031 and 721 exchange? ›
For those looking for diversification and more control over liquidity, a 721 UPREIT may be preferable. On the other hand, while a 1031 exchange offers more limited options for diversification, it allows investors to continue reallocating their real estate portfolio without incurring immediate tax liability.