What is a 1031 Exchange?

One of the downsides of investing in real estate is capital gains taxes. That’s why many investors turn to 1031 exchanges. This section of the U.S. Tax Code – 1031 – gives you an opportunity to exchange “like properties” in order to defer taxes on properties in exchange for investment opportunities.

This article will give you some scenarios where this applies and a better understanding of the 1031 exchange, but it’s important that you consult with your accountant and attorney to ensure you are following the rules. Let’s take a closer look.

When you sell a property, “RC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.”

What constitutes a like-kind exchange?

There are several scenarios for like-kind exchanges including a simultaneous property swap, a deferred exchange and a reverse exchange. Here’s a breakdown of how each one works:

• Simultaneous swap – This is the simplest 1031 exchange. It’s simply swapping one property for another like-kind property.
• Deferred exchanges – These allow you to bow out of a property and acquire one or more replacement properties. This is not as simple as selling a property off and using the profits to purchase another investment property. The transaction has to be structured so that the disposal and acquisition are part of the same transaction. You often work through an exchange facilitator to handle the deferred exchange.
• Reverse exchange – In this case, you gain a replacement property for your disposed property via an exchange accommodation titleholder. The property can be “parked” for no more than 180 days. During the parking period, you sell off the relinquished property to close the exchange.

Do all properties qualify for a like-kind exchange?

Not exactly. The main implication is that the property must be help for use in trade, business or for investment. You cannot work a 1031 exchange on your personal properties.

Here are a few more qualifications:

The properties must be similar – in nature, character or class. For example, a piece of land with a house can be exchanged for vacant land. There is an exception to this this rule. Properties inside the U.S. cannot be like-kind to properties outside the U.S.

There are other implications on other types of property, but we are discussing real estate here. If you’re looking to exchange other property, you’ll need to read the 1031 code for the rules.

What does not qualify for 1031 exchanges?

Several real estate investment assets do not apply to the 1031 exchange rules and they include:

• Inventory or stock in trade
• Stocks, bonds, or notes
• Other securities or debt
• Partnership interests
• Certificates of trust

Are there time limits?

The deferred exchange does have a couple of time limits you need to be aware of. First, you have 45 days from your sell date on your relinquished property to locate replacement property. You must notify someone involved in the exchange (seller or intermediary) in writing before this time limit is up of your intention. Then, you have 180 days or until the “due date of the income tax return for the tax year in which the relinquished property was sold” to complete the exchange. The IRS looks at the earlier date as the rule.

How do you report a 1031 exchange?

You have to file the IRS form 8824 with your tax return for the year in which the exchange occurred.

For more information on 1031 exchanges, read this Fact Sheet from the IRS and the entire 1031 exchange code. Again, be sure to consult your tax advisor on how to handle these exchanges to make sure you follow all the rules.