A 1031 exchange, often referred to as a like-kind exchange, is a transaction in which one investment property is swapped for another, allowing for the deferral of capital gains taxes. This term originates from Section 1031 of the Internal Revenue Code (IRC). It is commonly used by real estate agents, title companies, investors, and others. Some even use it as a verb, saying, “Let’s 1031 that building for another.”
However, it’s important to understand the complexities of IRC Section 1031 before attempting to use it. For instance, exchanges can only be made with properties of like kind, and the IRS has specific rules that limit its application to vacation properties. Additionally, there are tax implications and time frames that may pose challenges.
Whether you’re considering a 1031 exchange or simply curious about the rules, it’s crucial to familiarize yourself with the details to ensure compliance and make informed decisions.
Key Considerations
- A 1031 exchange is a tax deferral strategy that allows you to sell an investment or business property and replace it with a new property, deferring capital gains tax on the sale.
- Proceeds from the sale must be held in escrow by a qualified intermediary, and you cannot receive them, even temporarily, to maintain the tax-deferred status of the exchange.
- The properties being exchanged must be considered like-kind in the eyes of the IRS, meaning they must be of similar nature or character for capital gains taxes to be deferred.
- If used correctly, there is no limit on how frequently you can do these exchanges, allowing for potential tax deferral and flexibility in real estate portfolio management.
- The rules of a 1031 may also apply to a former principal residence under very specific conditions, providing additional opportunities for tax deferral strategies.
What Is Section 1031?
Generally, a 1031 exchange involves swapping one investment property for another. While most property swaps are taxable as sales, if your exchange meets the requirements of Section 1031 of the Internal Revenue Code (IRC), you may not owe any taxes or only limited taxes at the time of the exchange.
Essentially, a 1031 allows you to change the form of your investment without triggering a capital gain according to the IRS. This means your investment can continue to grow tax-deferred. There is no limit on how frequently you can do a 1031, allowing you to roll over gains from one investment property to another and potentially keep deferring taxes for multiple exchanges.
While you may profit from each swap, you can defer paying taxes until you sell for cash many years later. If the exchange goes as planned, you may only be subject to one tax payment at a long-term capital gains rate (currently 15% or 20%, depending on income, and 0% for some lower-income taxpayers as of 2022).
To qualify for a 1031, the requirement of “like-kind” property can be surprising as it doesn’t necessarily mean what you might think. For example, you can exchange an apartment building for raw land or a ranch for a strip mall, as the rules are quite liberal. However, there are potential traps for the unwary.
It’s important to note that the 1031 exchange provision is primarily intended for investment and business properties, although there are specific conditions under which it can apply to a former principal residence.
Additionally, while there are ways to use these exchanges to swap vacation homes, it’s worth noting that this loophole is much narrower than it used to be. There may be more restrictions and limitations involved.
IRS 1031 Exchange Rules
Traditionally, an exchange involves a straightforward trade of one property for another between two parties. However, it is unlikely to find someone who has the exact property you desire and who also wants the exact property you own. This is why the majority of exchanges are either delayed, three-party, or Starker exchanges (named after the first tax case that permitted them).
In a delayed exchange, you require the services of a qualified intermediary (a middleman) who holds onto the cash after you sell your property and uses it to purchase the replacement property for you. This three-party exchange is regarded as a swap.
In a delayed exchange, there are two essential timing rules that you must abide by.
45-Day Rule
The first rule pertains to designating a replacement property. Once you have sold your property, the intermediary receives the cash, and you cannot receive it without invalidating the 1031 treatment. Within 45 days of selling your property, you must provide written notice to the intermediary, indicating the replacement property you intend to acquire.
According to the IRS, you can designate up to three properties, provided you eventually close on one of them. If these properties meet certain valuation tests, you may even designate more than three.
180-Day Rule
The second timing rule in a delayed exchange pertains to closing. You must complete the purchase of the replacement property within 180 days of selling your old property.
Reverse Exchange Rule
It is also possible to purchase the replacement property before selling the old one and still qualify for a 1031 exchange. In such a scenario, the same 45- and 180-day time frames apply.
To meet the requirements, you must transfer the new property to an exchange accommodation titleholder, identify a property for exchange within 45 days, and then finalize the transaction within 180 days after acquiring the replacement property.
Are There Special Rules on Depreciable Property?
Special rules come into play when a depreciable property is involved in a 1031 exchange, as it can trigger a profit called depreciation recapture that is taxed as ordinary income.
Typically, if you exchange one building for another building, you can avoid this recapture. However, if you exchange improved land with a building for unimproved land without a building, the depreciation you previously claimed on the building will be recaptured as ordinary income.
These complexities highlight the importance of seeking professional assistance when using a 1031 to ensure compliance with the rules and regulations.
1031 Tax Implications
It’s important to note that in a 1031 exchange, you may have cash remaining after the intermediary acquires the replacement property. This cash, referred to as “boot,” will be paid to you by the intermediary at the end of the 180-day period. However, this boot will be taxed as partial sales proceeds from the sale of your property, typically treated as a capital gain.
One common pitfall in these transactions is overlooking loans. It’s crucial to consider any mortgage loans or other debts associated with both the property you relinquish and the replacement property. Even if you don’t receive cash back, if your liability decreases, it will still be treated as income, similar to cash.
For example, if you had a $1 million mortgage on the property you sold, but the mortgage on the replacement property you received in the exchange is only $900,000, you would have a $100,000 gain classified as boot, subject to taxation. It’s essential to carefully consider all debts and liabilities involved in a 1031 exchange to avoid potential tax consequences.
What Is an Example of a 1031 Exchange?
Let’s say you sell a rental property for $500,000 and want to use the proceeds to purchase another investment property. Instead of paying capital gains tax on the sale, you decide to do a 1031. You find a qualified intermediary who holds the sales proceeds in escrow.
Within 45 days, you identify a replacement property, such as a commercial office building listed for $550,000. You use the sales proceeds held by the intermediary to purchase the replacement property within 180 days.
By doing so, you’ve completed a 1031 exchange, deferring the capital gains tax on the sale of your original property. You’ve acquired a new investment property, and your tax basis in the new property is the same as the basis in the property you sold, allowing you to continue growing your investment in a tax-deferred manner. It’s important to note that specific rules and requirements must be followed for a 1031 to qualify for tax-deferred treatment, and professional guidance is recommended.
What Is Depreciation Recapture in a 1031?
Depreciation is a tax strategy that allows real estate investors to deduct the costs of property wear and tear over time, resulting in lower taxes. However, when the property is sold, the IRS may recapture some of those deductions and include them in taxable income.
With a 1031 exchange, you can delay this recapture event by rolling over the cost basis from the old property to the new property that replaces it. This means that you can continue to calculate depreciation on the new property as if you still owned the old property, helping to defer taxes and preserve your investment’s tax benefits.
Final Thoughts
A 1031 exchange is a tax-deferred strategy that smart real estate investors can use to build wealth. However, due to the complexity and various moving parts involved, it’s important to not only understand the rules but also seek professional assistance, even for experienced investors.