What is a 1031 Exchange?

Written by Ashley Sutphin Posted On Wednesday, 17 August 2022 00:00

An important part of real estate investing for some people, a 1031 exchange lets you swap one investment property for another. Then, in doing so, you’re deferring capital gains taxes. The name of the exchange comes from Section 1031 of the Internal Revenue Code.

IRC Section 1031 includes many different elements that a real estate investor needs to know and understand before using it. An exchange, for example, can only be made with like-kind properties. The IRS also has rules limiting the use of 1031 exchange for vacation properties, and time frames and tax implications can create problems if you aren’t aware of what they are.

The following is a general overview of a 1031 exchange and what to know.

What Is It?

A 1031 exchange works as a tax break that lets you sell a property held for investment or business purposes, swapping it for another that you purchase for the same purpose. Then, you can defer capital gains taxes that you’d pay on the sale.

The proceeds of your real estate sale must be held in escrow by a third party. Then, you’re required to use those proceeds to buy a new property. You can’t receive them even for a brief period of time, or you won’t qualify.

If you do it properly, there isn’t a limit on how often you can do a 1031 exchange. The rules can apply to former primary residences only under very specific conditions.

To put it in the simplest possible terms, you’re swapping one investment property for another. Most swaps are taxable since they’re sales, but if you meet the 1031 requirements, you will have no tax or a limited amount of tax owed at the time of the exchange.

You are, at least from the perspective of the IRS, not cashing out or recognizing capital gains. So then, you can keep growing your investment on a tax-deferred basis.

The ultimate goal for most investors is typically to pay only a single tax at a long-term capital gains rate, which depending on your income, is either 15% or 20%, and 0% for some taxpayers who are lower income.

Like-Kind

To qualify, most exchanges need to be of like kind. This is a broad term. The rules are very liberal as far as what applies as like-kind. The rules can even apply to a former primary residence under certain conditions. You can also use the exchange for vacation homes, but that’s not as liberal in the interpretation.

The Rules

An exchange traditionally involves simply swapping one property for another between two people. The chances of finding someone with an exact property you want who also wants the exact property you have isn’t likely, however. That’s why most exchanges are delayed, Starker exchanges or three-party exchanges.

In delayed exchanges, you need a qualified intermediary who is a middle person. That middle person holds the cash after you sell your property and then uses it to buy a replacement. The three-party exchange is treated like a swap.

There are two rules that you have to follow as far as timing with delayed exchanges. First is the 45-day rule. Once you sell a property, the intermediary receives the cash. You can’t receive it. Within 45 days of selling a property, you have to designate in writing the replacement property to the intermediary, specifically letting them know which property you want to acquire. According to IRS rules, you can designate three properties as long as you end up closing on one of them. If properties fall into certain valuation tests, you might be able to designate more than three.

There’s another timing rule, which is dubbed the 180-day rule. This relates to closing. You have to close on a new property within a period of 180 days of selling your old property.

There’s also the reverse exchange. You can buy a replacement property before you sell the old one and still qualify for the exchange, with the same time windows applying. You must transfer the new property to an exchange accommodation titleholder to qualify for this. You must identify a property for an exchange within 45 days, and then within 180 days, you must complete the transaction once you buy the replacement property.

Cash and Debt

If you have cash left after an intermediary acquires the replacement property, it will be paid to you at the end of 180 days. This is known as boot, taxed as partial sales proceeds from selling your property. It’s generally taxed as a capital gain.

Vacation Homes

Finally, there’s a question that arises regarding vacation homes. There was at one point a loophole that would let people use 1031 exchanges for vacation homes, but it was tightened in 2004. You can turn a vacation home into a rental property and still qualify for a 1031 exchange. The property would be disqualified if you offer the home for rent but don’t have tenants.

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