How to Defer All of Your Gain in a 1031 Exchange

A 1031 exchange lets you defer the tax on the sale of investment real estate, but how much you defer depends on what you buy and how much you reinvest. To defer all of it, you need to get two things right.

1. Buy at least as much as you sold

Your replacement property, or properties, should cost at least as much as the net sales price of what you sold. If you buy for less, the difference is generally taxable.

You can buy more than one property to get there. Many investors split an exchange across two or three replacements.

2. Reinvest all of your net equity

Every dollar of your exchange proceeds should go into the replacement purchase. Any cash you keep is taxable, even if you buy a more expensive property.

How debt fits in

If you had a loan on the property you sold, you'll usually need a loan of at least the same amount on your replacement, or you'll need to bring in additional cash to make up the difference. Paying down debt without replacing it can create taxable gain.

The reverse doesn't work. Taking on a bigger loan doesn't offset cash you take out of the exchange. If you want cash, that portion will be taxable.

Watch your closing costs

Normal selling and buying costs, like commissions, title and escrow fees, and recording fees, can generally be paid from exchange funds. Other items that show up on a closing statement may not be. Loan fees, property tax prorations, and rents or deposits credited at closing can create small amounts of taxable boot if they're paid with exchange money. Have your CPA review the closing statements before both closings.

Plan your identification

You can only buy property you identified within 45 days of your sale. If your first choice falls through and you didn't identify a backup, you may not be able to complete the exchange. Most investors identify up to three properties, which you can do regardless of value.

Depreciation recapture is deferred too

A 1031 exchange defers both the capital gain and the depreciation recapture on your sale. Your basis carries over into the replacement property, so the deferred gain stays with you until you sell without exchanging.

Under current law, if you hold property until your death, your heirs generally receive it with a stepped-up basis. That's one reason some investors keep exchanging over the long term. It's a conversation worth having with your CPA and estate planning attorney.

If you can't reinvest everything

You don't have to defer all of your gain. A partial exchange, where you keep some cash or buy down, still defers tax on the portion you reinvest. Just decide before your sale closes, because once funds are with your QI, you generally can't take cash out until the exchange is complete.

Run the numbers early

Your CPA can tell you exactly how much you need to buy and reinvest, and what it costs if you keep some cash. Getting those numbers before you go under contract on your replacement property makes everything easier.

APX 1031 is a Qualified Intermediary. We don't provide tax or legal advice; talk with your CPA or attorney about your situation.