If you’ve owned a rental house or a small apartment building for a while, selling it can mean a large tax bill on the gain. A 1031 exchange — named for Section 1031 of the tax code — lets you defer that tax by reinvesting the proceeds into another investment property. It’s one of the most useful tools for building a portfolio, but the rules are strict and the deadlines don’t bend. I’m not a tax advisor, so bring your CPA in early, but here’s how it works from the real estate side.
Like-kind is broader than it sounds
For real estate, “like-kind” is broad. Generally, real property held for investment or business use can be exchanged for other real property held the same way — a rental house for a small apartment building, raw land for a retail building, or one building for several. What doesn’t qualify is your primary residence, property held mainly to resell (like a fix-and-flip) or real estate outside the United States. For most of our clients, the goal is to trade up into income-producing properties that fit where they want their portfolio to go.
The two deadlines run at the same time
Once your sale closes, two clocks start. You have 45 days to identify replacement properties in writing, and you must close on the replacement within 180 days of the sale, or by your tax return due date if that comes first. The 180 days include the first 45, so you don’t get 225 days. In a market with limited inventory, 45 days goes fast. That’s why we start looking at replacement properties before your current property goes on the market.
Don’t touch the money
You can’t receive the sale proceeds yourself, even briefly. A qualified intermediary — an independent third party, not your own agent, attorney or accountant — holds the funds and handles the exchange paperwork, and that agreement has to be in place before your sale closes. If you take cash out or buy a less expensive replacement, the difference (called boot) is generally taxable. To defer all of the tax, plan on reinvesting all of the proceeds into a property of equal or greater value.
Things to Consider
Are you ready to be a landlord at a bigger scale? Trading a rental house for a small apartment building can improve your cash flow, but it also means more tenants, more maintenance and more of Oregon’s landlord rules. If you’re tired of managing, a building with a property manager in place or a net-leased commercial property might fit better.
Do you already have a replacement in mind? If you sell first and can’t find the right property in 45 days, you may end up identifying something you’re not excited about just to save the exchange. Lining up options ahead of time gives you more choices and less pressure.
If you’re thinking about trading up, get in touch — we’ll help you line up the sale and the purchase so the timelines work.