Money Girl

The 1031 Exchange: How to Defer Capital Gains Like a Pro

Episode Summary

988. This week, Laura reviews how to use a 1031 exchange to legally defer capital gains taxes when selling an investment property. You’ll learn the strict IRS rules for "like-kind" properties, the critical deadlines you must meet, and how to keep 100% of your profits working for you.

Episode Notes

Find a transcript here.

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Episode Transcription

Imagine you’ve owned a rental property for years. You’ve managed the tenants, paperwork, and repairs, and are finally ready to sell the property. Whether you’re just tired of being a landlord or want to cash in on this real estate investment, let’s say the sale will give you a $100,000 profit.

While that sounds terrific, the reality is that, between federal and any state taxes, you might owe $30,000, leaving $70,000. But what if I told you that instead of having to pay the government, you could use a legal loophole to keep all your profit working for you?

This rule is called a 1031 exchange, and I’ll review the basics in this post. You’ll learn how to defer a real estate tax bill and use the government’s money to build your own wealth. Whether you’re considering buying your first rental property or are a seasoned landlord, you can’t afford to ignore this strategy.

Welcome back to episode 988 of Money Girl–I appreciate you downloading the show! I'm Laura Adams, an award-winning author, on-camera spokesperson, female money speaker, and founder of The Money Stack, my Substack newsletter.

If you want help achieving your money goals and building wealth this year, my next workshop is titled “Set Your Money Strategy for 2026: How to Prioritize & Achieve Financial Goals.” When you subscribe to The Money Stack, you’ll automatically get an invitation to this live event. I hope to see you there!

You can learn more, ask questions, and sign up for the Money Stack for free at LauraDAdams.com. Or leave a voice message with your question or comment by calling 302-364-0308. You can find all this information in the show notes.

What is a 1031 exchange in real estate?

A 1031 exchange is a tax-deferral strategy that allows real estate investors to sell a property and purchase a similar property without paying capital gains taxes at the time of sale. As with many IRS rules, the name comes from its section of the Internal Revenue Code.

With a 1031, you roll over profits from one property into another one. That allows you to continue growing your investment without losing a significant portion of your profits to taxes. However, a 1031 exchange has strict rules you must follow; otherwise, your profit will be subject to capital gains taxes, which could result in a large tax bill.

LISTEN ALSO: Selling your home? How to avoid capital gains tax

What are the 1031 exchange rules?

To qualify for a 1031 exchange and defer capital gains taxes, you must follow the following rules.

Keep funds with a qualified third-party. Your proceeds from a property sale must be held by a qualified intermediary (QI), such as a closing agent or attorney, who will transfer them to the seller of your replacement property. The QI ensures compliance with IRS regulations–so, be sure to work with someone experienced in 1031 exchanges.
Purchase a like-kind property. Your replacement property must be similar to the property you’re selling and must not be a personal residence. For instance, if you rent out the original property, you must rent out the new one.

However, the properties don’t have to look the same, be the same type, or be a one-for-one swap. You could exchange two single-family homes for an apartment building or a duplex for a commercial office, as long as they’re investment properties.

Purchase a replacement of equal or greater value. If you buy a less expensive property than your original, you must pay taxes on the difference. For instance, if you receive $100,000 in profit, but only spend $80,000 on a replacement property, you’d be subject to capital gains taxes on $20,000.
Purchase a replacement property by a deadline. You have 45 days to identify properties in writing, and 180 days to close on a new, like-kind property. Otherwise, you won’t qualify for a 1031 exchange and will lose tax deferral benefits.

Here are four steps you must follow for a successful 1031 exchange:

Sell your property. Your original property is also known as the relinquished property. As previously mentioned, you can’t receive the proceeds directly after closing on the relinquished property; they must be handled by a QI.
Identify a replacement property. After the closing date of your relinquished property, you have a short window of 45 days to identify one or more replacement properties by making written purchase offers.
Purchase the replacement property. You have 180 days to complete the purchase of a replacement property after the closing date of your relinquished property.
Defer capital gains taxes. If you reinvest all of the sale proceeds into a replacement property, you defer capital gains taxes and keep all your profit working for you by growing your real estate portfolio.

What are the benefits of a 1031 exchange?

Avoiding capital gains is the primary benefit or reason to consider a 1031 exchange. Depending on your income, tax filing status, and how long you’ve owned a property, the capital gains tax rate could be 15% to 20%, plus any applicable state taxes. You defer this tax with a 1031 exchange. It keeps your money working for you rather than going directly to the government.

You can make an unlimited number of 1031 exchanges in your lifetime, allowing you to defer taxes indefinitely if you continue to reinvest the sale proceeds into similar properties. Over time, this growth can significantly increase a real estate investor’s wealth.

In addition, a 1031 exchange allows investors to upgrade their properties. For example, you might sell a small rental property and use the proceeds to buy a larger multi-family building. That could generate higher rental income or appreciate at a higher rate, building your cash flow and net worth.

Another benefit of a 1031 exchange is that it can support estate planning. Your heirs may inherit your rental property at a stepped-up basis, meaning that there is no capital gains tax for them to pay.

For example, if you bought a rental property for $200,000 and it appreciates to $500,000 by the time of your death, your heirs skip the tax on the $300,000 of gains. So, rolling over profits means they could eventually be erased after your death.

What are the downsides of a 1031 exchange?

One downside of a 1031 exchange is that you must intend to hold the replacement property for investment or business use, such as owning it for at least one to two years. That means you can’t exchange a property that you want to quickly fix up and flip for a profit.

Also, be aware that owning a property for less than a year means gains are taxed at higher ordinary income rates, not at the more favorable capital gains rates.

Another downside is that the replacement property won’t be as profitable as you hoped, especially if the housing market changes. You could end up wishing you had taken the profit from your original property and settled with the government.

In addition, the time limits of a 1031 exchange could put unnecessary pressure on you to find a suitable like-kind property. If the housing inventory is low in the areas where you’re looking to buy, you may not be able to identify a property within 45 days.

If you’re interested in a 1031 exchange, a good strategy is to begin looking for replacement properties before selling your original property. That increases the likelihood that you can find a great property and avoid missing 1031 deadlines.

LISTEN ALSO: How to hire the best real estate agent

Is a 1031 exchange eligible for personal use?

Many real estate investors purchase rental properties they intend to use personally. For instance, you may offer short-term rentals on your beach condo or mountain house, while reserving a few weeks a year for yourself. Is that allowed in a 1031 exchange?

While the IRS generally says you can’t exchange a vacation home, there is a safe harbor rule that offers a loophole. For a 1031 exchange to be valid, you must meet the following rules for each of the two years after buying a replacement property:

You must rent it at a fair market value for at least 14 days a year.
You must limit your own personal use to 14 days or 10% of the rental days, whichever is greater. For example, if you rent the property on Airbnb for 200 days a year, you could only stay there for 20 days (10% of 200). If you rent it for 100 days, you may stay for up to 14 days.

By the way, exchanging a traditional long-term rental for a short-term rental is considered a like-kind purchase because both are investment properties.

Personal use is time spent at a property by you or any other person with an interest in it, such as a co-owner. It includes all family members staying for free or at a discounted rate. However, family can stay there if they use it as a primary residence and pay fair market rent.

Again, you must follow these rules for limited personal use for the first two years to prove your original investment intent to the IRS. But after that, you can use the property any way you like by extending your stays or moving in full-time.

To sum up, a 1031 exchange is a powerful rule that allows real estate investors to avoid taxes, keep their capital working, and support sound estate planning. However, you must follow the IRS rules carefully. I recommend working with a real estate professional who can guide you through a successful 1031 exchange to avoid costly mistakes.

That's all for now. I'll talk to you soon. Until then, here's to living a richer life!

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