In addition to primary residences, some 55+ adults own investment or rental properties to generate rent-based income. Active adults asking themselves “what is a 1031 exchange?” are likely thinking about (or in the process of) trying to sell such properties and potentially reinvest in a replacement.
If 55+ property owners decide it’s time to sell an investment property, they will need to pay a steep tax on any gains earned in the sale. The capital gains tax takes a considerable chunk out of profits and makes it more difficult to reinvest into replacement properties moving forward.
Luckily, a handy tax-deferral strategy called a 1031 exchange allows 55+ property owners to continue growing their equity while simultaneously reinvesting into more valuable properties. The 1031 exchange is a complex process full of strict rules and deadlines. Therefore, it’s crucial that 55+ sellers know what to expect and how to plan.
What Is a 1031 Exchange?
A 1031 exchange is a rewarding tax-deferal strategy for those looking to improve their real estate holdings over time. Active adults who want to maximize the value of their properties while reinvesting might be asking themselves, “what is a 1031 exchange?” and “how does a 1031 exchange work?”
A 1031 exchange is a powerful tax-deferal strategy that allows homeowners to reinvest into more valuable properties without losing equity on taxes right away. When someone sells an investment or rental property and makes a profit (called capital gain), they can invoke a 1031 exchange to defer paying the capital gains tax and instead reinvest in a property with a higher value.
The rules and deadlines involved in a 1031 exchange can make the process feel overwhelming. This is why we recommend consulting an experienced financial advisor to help you navigate the process. A successful 1031 exchange results in more buying power when reinvesting into more valuable properties. The ability to stack exchanges in succession has the potential for lifelong benefits.
What Types of Properties Qualify?
Only specific property types qualify for 1031 exchanges, namely those designated as investment or rental properties. Investment properties are real estate holdings that generate returns through tenant rents or future resale, according to Investopedia. Examples of these types of properties include:
- Long-term residential rental properties, such as rental single-family homes and apartment buildings
- Short-term rental properties, like vacation rentals or campgrounds
- Commercial rental properties, including offices, hotels, and multi-business buildings
- Empty land held for investment purposes that can be sold later once it’s appreciated in value
An important rule: Properties involved in 1031 exchanges must be what’s called “like-kind” properties. Like-kind is a broad term for all properties of the same designation. For 1031 exchanges, like-kind properties would be investment and rental properties. Also, any type of investment property can be mixed and matched on either end of the maneuver.
Properties designated for personal-use do not qualify, including primary residences, second homes, vacation properties, and other non-income-producing properties. This means you can’t sell your personal-use house and exchange it for an office building. If an investment property is converted to personal use, it’s no longer eligible for a 1031 exchange. Also, the capital gains tax deferred from previous exchanges must be paid at that time.
How a 1031 Exchange Works
A 1031 exchange requires careful planning, strict compliance with rules and deadlines, and a clear understanding of the process as a whole. Here are the three simplified steps of this powerful tax strategy:
- An investment or rental property is sold, and all capital gains are sent to a qualified intermediary (a third party required by the IRS to facilitate the exchange).
- A replacement like-kind property is identified within 45 days and purchased within 180 days.
- All proceeds are reinvested into the replacement property via the qualified intermediary, deferring the capital gains tax as long as all rules are followed and all requirements are met.
While there are several other complex rules and considerations, those three steps are the basic outline of a 1031 exchange. Active adults are encouraged to seek guidance from real estate and financial professionals to navigate the process.
Key Timelines and Rules to Know
Strict compliance with all rules and deadlines is crucial for a successful 1031 exchange. The IRS enforces these rules and deadlines to prevent sellers from exploiting loopholes.
After the sale of an investment property, the first deadline is the 45-day identification period. Within 45 days, the seller must identify a like-kind replacement property to reinvest the sale proceeds.
The replacement property (or properties) must be of equal or greater value than the relinquished property. Any proceeds left over from the exchange is taxable. One way to counteract this is with built-to-suit exchanges. This means you use excess profit to fund improvements on the replacement property. Conversely, if the net gains from the sale of the relinquished property do not completely cover the replacement property, sellers may use out-of-pocket cash to compensate.
After the replacement property is identified, the exchange must be completed within 180 days. If all goes according to plan, the capital gains tax on the relinquished property defers until the taxpayer sells a replacement property and does not complete a 1031 exchange. Neither the 45-day nor the 180-day deadlines can be extended.
Common 1031 Exchange Scenarios for 55+ Sellers
Despite the rules surrounding a 1031 exchange, it offers flexibility for 55+ sellers across a wide range of scenarios. The maneuver provides options when it comes to upgrading investment properties, consolidating or diversifying holdings, or changing locations.
A common 1031 exchange scenario is when 55+ sellers wish to invest in a property that’s more valuable than what they currently hold. Due to the tax deferral, sellers have more capital to invest in a replacement property that will either generate more rental income or eventually sell for a profit. It’s also possible to consolidate several properties into a single property or diversify a single property into multiple properties in exchange, expanding the options available to investors.
Property owners also use 1031 exchanges to reinvest in a different location. For example, an active adult may want an investment property closer to family or their new home after moving into a 55+ community. Luckily, a 1031 exchange can be done between any like-kind investment properties in the U.S., regardless of location. A 1031 exchange does not apply to properties outside the U.S.
Pros and Cons of a 1031 Exchange for 55+ Sellers
Benefits of a 1031 Exchange
The largest benefit of a 1031 exchange is the capital gains tax deferral. Being able to defer the tax gives 55+ sellers more capital to purchase additional, more valuable properties. The exchange allows sellers to upgrade their properties or buy more convenient properties without losing equity.
Another benefit is the flexibility of a 1031 exchange. Under the like-kind rule, 55+ sellers can reinvest in a wide variety of properties. This gives them options to make their holdings more manageable and convenient.
Limitations and Considerations
Beyond the 1031 exchange rules, restrictions, and deadlines, there are a few key limitations for 55+ sellers of investment properties. Those considering a 1031 exchange should ensure they have a high-level understanding of the process before committing.
Tax Deferral, Not Elimination
One key consideration is that this strategy is a tax deferral, not a tax exemption or elimination. Whenever an investor decides to pocket the profit from selling an investment property, they must pay the capital gains tax.
Since 1031 exchanges can be done multiple times in a row, active adults should know that capital gains tax basis carries over and accumulates for each property. Whenever the profit from a sale is held rather than reinvested, capital gains tax must be paid on all properties involved in past 1031 exchanges.
Estate Planning
55+ sellers should also take 1031 exchanges into account when estate planning. If someone continuously executes 1031 exchanges with their investment properties until the time of death, their heirs will not be required to pay the capital gains tax on any properties involved in past 1031 exchanges.
When the owner of an investment property passes, the property receives what is called a step-up basis when passed onto heirs and beneficiaries. A step-up basis resets a property to its fair market value, eliminating any past gain left to tax. This means that deferred capital gain taxes are never realized, and heirs do not have to pay them.
Ongoing Management Responsibilities
Maintaining investment and rental properties can require the time and effort that active adults aren’t willing to invest forever. Rental properties often require maintenance, upkeep, tenant management, cleaning and janitorial services, and unforeseen issues that require time, money, and patience.
Active adults should consider whether they want to carry out a 1031 exchange. This would mean managing another investment property, or they can take their gains and do something else with the money. A 1031 exchange is handy, but not necessarily the right fit for every 55+ property owner.
Working With the Right Professionals
For a 1031 exchange, working with the right professionals is not only highly advised but also required for the qualified intermediary. Active adults will find the exchange to be a multifaceted process that taps into real estate, taxes, and financial planning. It’s recommended to consult professionals in these fields well before a 1031 exchange.
A qualified intermediary (or QI) is a third party required by the IRS for all 1031 exchanges. The QI is responsible for holding funds from the sale of a property, facilitating the exchange for the replacement property, maintaining documentation, and ensuring that all tax-deferral procedures comply with applicable laws and regulations.
A QI must be an independent third party and not have a conflict of interest with the seller. If a 55+ seller touches the money gained from the sale of an investment property at any time in the process, the 1031 exchange is no longer possible. The seller will immediately be responsible for paying the capital gains tax and other taxes.
Given the strict deadlines for identifying and purchasing a replacement property, the expertise of a qualified real estate professional is highly recommended. A trusted real estate agent can help active adults sell their relinquished property, find replacement properties, and navigate all of the paperwork and processes.
Another professional worth speaking to is a trusted financial advisor. They can help active adults by ensuring all finances are in order for a 1031 exchange, especially if 55+ sellers need to pay any out-of-pocket amounts for the replacement property. They can also help create a plan for the future, including retirement, taxes, and financial goals.
FAQ: 1031 Exchanges
What is a 1031 exchange?
A 1031 exchange is a tax-deferral strategy that allows you to sell an investment or rental property and reinvest the proceeds into another qualifying property without immediately paying capital gains taxes.
How does a 1031 exchange work?
After selling an investment property, the proceeds are held by a qualified intermediary. You then have 45 days to identify a replacement property and 180 days to complete the purchase, following strict IRS guidelines.
What types of properties qualify for a 1031 exchange?
Only investment or business-use properties qualify. This includes rental homes, apartment buildings, commercial properties, and land held for investment. Primary residences and vacation homes used for personal purposes do not qualify.
Can I do a 1031 exchange on my primary residence?
No. A 1031 exchange applies only to investment or business properties. However, different tax rules may apply if you are selling a primary residence.
What does “like-kind” property mean?
“Like-kind” refers to properties that are similar in nature or use. For real estate, this definition is broad—most investment properties can be exchanged for other investment properties, regardless of type.
What are the 45-day and 180-day rules?
You must identify a replacement property within 45 days of selling your original property. The purchase of the replacement property must be completed within 180 days of the original sale.
Do I have to buy a property of equal or greater value?
Yes. To fully defer capital gains taxes, the replacement property must be of equal or greater value, and all proceeds must be reinvested.
What happens if I miss a deadline?
If you miss either the 45-day identification deadline or the 180-day closing deadline, the exchange will fail, and you will owe capital gains taxes on the sale.
Do I need a qualified intermediary (QI)?
Yes. The IRS requires a qualified intermediary to hold the sale proceeds and facilitate the exchange. You cannot take possession of the funds yourself.
Does a 1031 exchange eliminate taxes?
No. A 1031 exchange defers capital gains taxes—it does not eliminate them. Taxes are owed when you sell a replacement property without completing another exchange.
Can I do multiple 1031 exchanges over time?
Yes. Many investors complete multiple exchanges over their lifetimes, potentially deferring capital gains taxes by reinvesting in new properties.
Can I move into a property after completing a 1031 exchange?
There are specific rules governing the conversion of an investment property into a personal residence. Generally, you must hold the property as an investment for a period of time before converting it to personal use.
Are there risks involved in a 1031 exchange?
Yes. The process is complex, involves strict IRS rules, and requires careful planning. Market conditions, financing challenges, and timeline pressure can also create risks.
Can I exchange property in one state for property in another?
Yes. As long as both properties are located within the United States and meet the investment-use requirement, you can exchange across state lines.
Is a 1031 exchange right for retirees or 55+ property owners?
It can be, especially for those looking to reposition investments, consolidate holdings, or move properties closer to home. However, because it involves ongoing property ownership and management, it’s important to weigh long-term goals and consult financial and real estate professionals before proceeding.
Making Informed Decisions About Your Next Move
55+ property owners will find that 1031 exchanges can offer flexibility when reinvesting in another property. Those considering this strategy should review all options, limitations, and benefits before selling their investment property.
Active adults looking to explore next-step housing with confidence should connect with a local 55places real estate expert. Our team provides unparalleled insight into selling strategies, 55+ community options, and real estate market trends.
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