How To Use the Like Kind Exchange for Rental Property

As a real estate investor, you’ve probably heard the term “like kind exchange” come up in conversation.

A like kind exchange (also known as a “1031 exchange”) is a real estate transaction that allows you to sell a property and reinvest the profits into a new property without paying capital gains taxes. In order to qualify for a 1031 exchange, the new property needs to be purchased within a specific time frame after the original property was sold, and it needs to be managed as one transaction.

1031 exchanges are complicated transactions, but when you understand how to do a 1031 exchange (and execute it correctly), you can avoid paying a significant amount of taxes when you sell a rental property —which puts money right back in your pocket.

But how does the 1031 exchange affect rental properties? What do you need to know in order to successfully manage 1031 exchanges on your properties? And how can you make a like kind change work for you and your business?

Why the Like Kind Exchange Is Beneficial for Rental Property Owners

The like kind exchange can be beneficial for a variety of real estate transactions (like purchasing farm land), but there’s one type of transaction it’s particularly beneficial for: a 1031 exchange of rental property — which, as an owner of rental properties, is particularly beneficial for you.

When you sell a rental property without a 1031 exchange, you’re on the line for a hefty amount of taxes. First, you would need to pay taxes on any profit you made from the sale. And if you claimed depreciation of the property on your taxes and sold the property for higher than the depreciated value, you’d have to pay taxes on the difference (known as the “recaptured depreciation”) as well.

That’s a lot of taxes!

But the 1031 exchange allows you to transfer the profits and recaptured depreciation to another property —and avoid paying all of those taxes in the process.

For a rental property owner, that is beneficial for a number of reasons. First off, saving all that money on taxes is adding revenue back into your business. When you do a 1031 exchange, you don’t need to come up with a down payment (since you’re reinvesting your profits), which frees up cash flow elsewhere in your business. 1031 exchanges also allow you to offload properties that have depreciated in value and add newer, better properties to your portfolio — which will always be a better investment in the long run.

Clearly, like kind exchanges are something you want to do as a rental property owner. But what are the rules? And how, exactly, do you do it?

1031 Exchange Rules

Using the 1031 exchange for rental property can have a big payoff — but only if you do it correctly. There are a lot of rules to properly process a 1031 exchange, and if you don’t follow the rules, you can find yourself having to deal with a hefty bill from the IRS.

Here are the main rules for the 1031 exchange:

The same taxpayer must be both the buyer and the seller in the 1031 exchange; the tax return and name on the title of the property being sold must be the same as the tax return and titleholder that purchases the property (if you have a single-member LLC, you can sell through your LLC and purchase with your individual name).

Following the closing on the first property, the person managing the 1031 exchange has 45 calendar days to identify potential replacement properties.

In terms of properties, 1031 exchangers can identify three properties of any value, four properties (or more) as long as the value does not exceed 200% of the original property sold, or — if the value is higher than 200% — they must follow the 95% rule, which states that 95% of the properties identified must be purchased.

The new property must be purchased within 180 days of the closing date of the original property sale.

In order to defer 100% of taxes, the property sold must be equal to or greater than the property being purchased; otherwise 1031 exchangers must pay taxes on the difference in value.

Equity and debt in the new property must be equal to or greater than equity and debt in the property sold (additional equity in the new property can offset debt, but additional debt can not offset equity).

The property purchased must be used as a business or investment property; the 1031 exchange of a rental property to a primary residence or second home is not valid.

In order to qualify for the 1031 exchange, the replacement properties must be held for a certain amount of time (there’s a big gray area with this rule, but typically you need to hold onto a property for 24 months for it to count as an investment property).

The property sold must be a business or investment property; primary residences do not qualify.

As you can see, there are a lot of rules attached to the 1031 exchange and, as mentioned, if you don’t follow them all, you can find yourself facing a large tax bill. To learn more about the 1031 exchange rules — and how they apply to buying and selling rental properties — visit the IRS website.

The 1031 Exchange How-To

Now that you know how a 1031 exchange can add revenue to your investment business — and rental properties to your portfolio — as well as what rules and guidelines you need to follow, let’s talk about how, exactly, to use the exchange.

Step 1: Hire a Professional

Unless you have experience successfully managing 1031 exchanges, you’ll definitely want to hire a tax or finance professional to manage the deal. Because it’s so important that every rule is followed in order to avoid taxes, a 1031 exchange isn’t an area in which you want to DIY.

Step 2: Find a Buyer

Next up is finding a buyer for your existing property. Once you’ve identified a buyer, you’ll need to add 1031 exchange-specific language to your purchase and sale agreement that notifies the buyer of your intent to use the transaction as part of a 1031 exchange (your tax or finance professional can help with this).

Step 3: Find a Qualified Intermediary

Because the selling of your current property and the purchase of your new property needs to be handled as one transaction in order to qualify for the exchange, you’ll need what’s known as a “qualified intermediary” to handle the funds throughout the process. Typically, your qualified intermediary will either be a bank or a law firm.

Step 4: Exchange Agreement With Qualified Intermediary

Once you’ve identified your qualified intermediary, you’ll need to enter into an exchange agreement that allows them to receive the funds from your property sale, hold them, and then use them to purchase your replacement property. It’s important that the agreement states that you assign both buyer’s and seller’s rights to your intermediary (otherwise, the transaction won’t qualify for the 1031 exchange). You’ll also need to enter into this agreement before the closing date for the sale of your original/relinquished property.

Step 5: Identify the Properties You Want to Buy

Once you have your exchange agreement, it’s time to start looking for properties!

Step 6: Tell Your Qualified Intermediary to Enter a Purchase and Sale Agreement With Your New Sellers

Once you have the property you’d like to buy, instruct your qualified intermediary to enter a purchase and sale agreement with the sellers of the new property. Just like in the purchase and sale agreement you had with the buyers of your original property, it’s important to include 1031 exchange-specific language in the agreement.

Step 7: Complete the Exchange

You have 180 days from the sale of your original property to complete the exchange and receive title to your new, replacement property.

Step 8: Fill Out Form 8824

Once the exchange is complete, you’ll need to fill out IRS Form 8824 (available on the IRS website) in the tax year in which the exchange occurred in order to qualify for the exchange’s tax benefits.

As you can see, the 1031 exchange process is a complex one — one misstep, and you can find yourself having to pay taxes you weren’t anticipating, which can hurt your investment business.

That's why it’s so important to hire a tax or financial professional to help manage the process. A professional with experience managing 1031 exchanges can advise you on how to effectively use the 1031 exchange to your benefit. Moreover, they can make sure everything is done properly and you don’t end the exchange with a hefty tax bill.

1031 exchanges are hugely beneficial for rental property owners. Now that you know how they work, you can use them to your advantage — to buy more properties, build your investment portfolio, and increase your profits.

How to Use the Like Kind Exchange (1031) for Rental Property