The Basics of 1031 Real Estate Exchanges

For real estate investors, selling an investment property can create a significant tax liability. Under certain circumstances, taxpayers may be able to defer the taxes by completing a 1031 exchange, commonly known as a like-kind exchange. This strategy allows investors and owners to sell one qualifying property and reinvest the proceeds into another like-kind property, potentially deferring recognition of capital gains.

What is a 1031 Exchange?

A 1031 exchange allows an investor to exchange one investment or business real property for another property of like-kind. While directly swapping property with another taxpayer is permitted, the IRS provides for an alternative that allows a taxpayer’s property to be sold and then the proceeds used for a replacement property in a separate transaction. Instead of the taxpayer receiving the proceeds of the sale and paying taxes on the gain in the year of sale, the investor will reinvest the proceeds into a replacement property to defer the gain on sale.

Note that a 1031 exchange is generally a tax deferral and not a way to eliminate the tax completely. The gain is carried over into the replacement property and will become taxable when that replacement property is sold, unless another 1031 exchange is initiated.

A personal residence does not qualify for a 1031 exchange. The properties must be held for investment or used in a trade or business.

What does “like-kind” mean?

One of the most common misconceptions about 1031 exchanges is that the replacement property must be identical to the property being sold. The term “like-kind” is very broad.

An investor could potentially exchange an apartment building for a commercial property, vacant land, or another type of property if it is qualifying real estate. They do not have to be the same type of real estate if they meet the requirements.

Not every type of property qualifies. It is important to check with your tax advisor to confirm your properties qualify.

The Timeline of a 1031 Exchange

Timing for a 1031 exchange is crucial. There are two deadlines that must be met in order for your 1031 exchange to be valid. After selling the initial property, the investor has 45 days to identify the potential replacement property.

The investor has from the earlier of 180 days from the relinquished property sale or the due date (including extensions) of the federal income tax return for the tax year in which the sale occurred to acquire the replacement property. An important note, the 180 days includes the 45-day period to identify. In order to achieve full tax deferral, the general rule is that investors should be looking at properties at least equal in value to the relinquished property. Buying a cheaper property does not invalidate the 1031 exchange but it can result in less than full gain deferral.

What is the Role of a Qualified Intermediary?

The qualified intermediary (QI) holds the funds from the sale of the relinquished property. This is to ensure that the investor never has actual or constructive receipt of the sales proceeds. A QI takes control of the funds while the process is in motion until the replacement property is acquired.

It is important to understand this role and how crucial it is to have a QI. Your accounting firm or legal team can help direct you to someone who can assist with this process.

Why use a 1031 Exchange?

The primary benefit of a 1031 exchange is to defer taxes while being able to invest in new real estate. This allows investors to acquire larger properties without the burden of the tax liability associated with a sale.

A 1031 exchange is a very valuable tool to use, but it is important to follow the strict deadlines when trying to complete an exchange. This should be planned well before the original property sells. It is important to have a trustworthy accounting firm and legal team to ensure your 1031 exchange is valid.