What You Should Know About Unwinding a 1031 Exchange | DST Investment

If you’re getting ready to sell property, you may have heard of the 1031 exchange option. This type of exchange allows you to sell your property and reinvest the proceeds into another property without paying any capital gains taxes. 

However, there are some situations where you may need to unwind, or cancel, a 1031 exchange. In this article, we’ll explain what a 1031 exchange is, how to unwind one, and what the tax implications are to help you make the best decision for your situation.

What is a 1031 Exchange?

A 1031 exchange, also called a like-kind exchange or a Starker exchange is a transaction that allows you to sell one investment property and buy another without paying any capital gains taxes on the sale. 

1031 exchanges are commonly used in real estate investing because they allow you to reinvest your profits into another property and continue to grow your portfolio without being taxed on the sale. 

In order to qualify for a 1031 exchange, you must meet the following criteria: 

  • The property must be held for investment or business purposes (you can’t exchange your primary residence). 
  • The properties must be “like-kind.” This means that they must be of the same type or nature. For example, you can exchange an office building for an apartment complex, but you can’t exchange an office building for a truck.
  • You must identify the property you want to purchase within 45 days of selling the original property. 
  • You must close on the new property within 180 days of selling the original property 

If you meet all of the criteria, you can complete a 1031 exchange and defer paying any capital gains taxes on the sale. 

However, there are situations where you may need to cancel, or unwind, a 1031 exchange. Let’s take a look at how to do that.

How to Unwind a 1031 Exchange

There are two main ways to unwind a 1031 exchange: through a reversal or through a non-qualified use. 

A reversal is when you cancel the exchange before you’ve purchased the replacement property. In this case, you would need to pay capital gains taxes on the sale of the original property. 

A non-qualified use is when you purchase the replacement property but don’t use it for investment or business purposes. This could happen if you decide to live in the property yourself or sell it before you’ve held it for at least one year. If this happens, you’ll have to pay capital gains taxes on the sale of the original property as well as any depreciation recapture taxes on the replacement property. 

It’s important to note that you can’t simply decide to unwind a 1031 exchange. You’ll need to work with a qualified intermediary, or QI, to cancel the exchange. A QI is a third party who holds the proceeds from the sale of the property and facilitates the purchase of the replacement property. 

If you’re thinking about unwinding your 1031 exchange, you should speak to a tax professional to discuss your options and understand the tax implications. 

What are the Tax Implications of Unwinding a 1031 Exchange?

The biggest tax implication of unwinding a 1031 exchange is that you’ll have to pay capital gains taxes on the sale of the original property. 

If you complete a reversal, you’ll pay capital gains taxes on the entire sale price of the property. 

If you complete a non-qualified use, you’ll pay capital gains taxes on the difference between the sales price and your basis in the property. You’ll also have to pay depreciation recapture taxes on any depreciation taken on the replacement property. 

Either way, unwinding a 1031 exchange can be a costly mistake if you’re not careful. That’s why it’s so important to speak to a tax professional before making any decisions. 

Benefits of Unwinding a 1031 Exchange 

While there are some drawbacks to unwinding a 1031 exchange, there are also some benefits. 

First, unwinding an exchange can be a good way to get out of an investment that’s not performing well. If you’re losing money on a property, it may make sense to sell it and take the capital gains hit rather than continue to hold onto it and lose even more money. 

Second, unwinding an exchange can provide flexibility in your real estate portfolio. Let’s say you’ve been trying to buy a piece of land for your business but haven’t been able to find anything that meets your needs. If you were to unwind your 1031 exchange, you could use the proceeds from the sale of your investment property to buy the land outright. 

Lastly, unwinding an exchange can be a good way to access cash that you may need for other purposes. Let’s say you have a 1031 exchange property that’s worth $1 million, and you need $500,000 in cash for a down payment on a primary residence. If you unwind the exchange, you could use the $500,000 to make the down payment and then hold onto the remaining $500,000 as cash. 

Important Factors to Consider

There are a few important factors to consider before unwinding a 1031 exchange. 

First, you need to make sure that you actually qualify for a 1031 exchange. If you don’t, then you may be better off just selling the property and paying the capital gains taxes. 

Second, you need to weigh the costs of unwinding the exchange against the benefits. If you’re going to have to pay a lot in taxes, it may not be worth it to cancel the exchange. 

Finally, you need to consider the timing of your decision. If you wait too long to decide, you may not be able to reverse the exchange. 

If you’re thinking about unwinding a 1031 exchange, talk to a tax professional to see if it’s the right decision for you. They can help you understand the tax implications and make sure you’re making the best decision for your situation.

Final Thoughts

There may come a time when you need to unwind a 1031 exchange. Whether you’re reversing the exchange or using the property for a non-qualified purpose, it’s important to understand the tax implications before making any decisions. 

If you have any questions about unwinding a 1031 exchange or need help with your real estate investment strategy, we encourage you to speak to one of the knowledgeable professionals at our firm. We’re here to help you grow your portfolio and reach your goals.