The 1031 exchange can be a great tool to increase your cash flow by deferring taxes. It has been used by savvy real estate investors for decades. Through a properly executed 1031 exchange, you can legally delay paying taxes on investment gains when you sell a qualified property.
The premise is simple: Whenever you sell business or investment property for a gain, you generally have to pay tax on the gain at the time of the sale. IRC Section 1031 provides an exception. You can postpone paying tax on the gain if you reinvest it in a similar, “like-kind” property.
The key difference is that you’re exchanging, rather than selling. This allows you to qualify for the deferred tax treatment of your gain. Simply put: At the time of the sale, 1031 property exchanges are not taxed.
That’s easy enough to understand, but there are IRS rules you must follow. And some misinformation out there. I hope to clear some of that up in this article.
First, a disclaimer: I’ve distilled the content of this article by studying the IRS publications, researching important cases supporting the tax law and consulting with a few experts. However, I’m neither a tax accountant nor a lawyer, so the points in this article should not be considered tax advice.
With that out of the way, here are six key things to know if you’re considering a 1031 exchange.
#1: Only Certain Entities and Types of Assets Qualify for the 1031 Exchange
A 1031 exchange is somewhat similar to a traditional tax-deferred IRA or 401(k) retirement plan. Transactions made within your retirement plan — selling the shares of a fund, for example — are not a taxable event. The capital gains that would otherwise be taxable are deferred when you sell assets within your retirement plan. You’re exchanging one income-producing asset for another. You don’t pay taxes until you withdraw cash from a qualified retirement plan.
The same principle holds true for tax-deferred exchanges of real estate investments. As long as the money continues to be reinvested in similar real estate assets (and you follow all the rules), the capital gains tax can be deferred.
Many taxpaying entities can qualify for a 1031 exchange. Individuals, C corporations, S corporations, partnerships, LLCs and trusts are the primary ones.
It is most often used in connection with sale of real estate property. But some exchanges of personal property can qualify under Section 1031 too. Certain types of property are specifically excluded from Section 1031 treatment, including:
- Inventory or stock in trade
- Stocks, bonds or notes
- Partnership interests
- Certificates of trust
The big idea behind the 1031 exchange is that since the taxpayer is merely exchanging one property for another of “like-kind,” there is nothing received by the taxpayer that can be used to pay taxes. In addition, the taxpayer has a continuity of investment by replacing the old property. All gain is still locked up in the exchanged property, so no gain or loss is “recognized” or claimed for income tax purposes.
#2: You Need a Qualified Intermediary to Handle the Execution of the 1031 Exchange
The 1031 financial transactions, starting with the proceeds from the sale of the old property, must go through the hands of what’s termed a “qualified intermediary.”
The intermediary holds all the profits from the sale and then disburses those monies at the closing of the exchanged property (or sometimes for fees associated with acquiring the new property). In order to be qualified, the entire amount of the cash proceeds from the original sale has to be reinvested toward acquiring the new real estate property. Any cash retained by you from the sale of the old property is taxable income.
At the close of the relinquished property sale, the proceeds are sent by the title company handling the closing directly to the qualified intermediary. That person or entity holds the funds until the transaction for the replacement property acquisition is ready to close. Then the proceeds from the sale of the relinquished property are deposited by the qualified intermediary to purchase the replacement property. After the acquisition of the replacement property closes, the qualified intermediary delivers the property to the taxpayer, all without the taxpayer ever having what the IRS calls “constructive receipt” of the funds.
The intermediary is “qualified” according to the IRS because he/she is an independent party with the sole purpose being to facilitate the exchange process. You cannot act as your own facilitator. And your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) cannot act as your intermediary.
#3: The Properties Must Be “Like-Kind” to Qualify
IRC Section 1031 allows you to postpone paying tax on gains only if you reinvest the proceeds in a similar or “like-kind” property. Like-kind property is property of the same nature, character or class. Quality or grade doesn’t matter. Most real estate will be like-kind to other real estate. But there are exceptions. For example, real estate property located within the U.S. is not like-kind to property outside of the U.S.
Real property and personal property can both qualify as exchange properties under Section 1031. However, real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real estate property. For example, cars are not like-kind to trucks.
There are other rules related to “like-kind.” Here are two important ones:
- The total purchase price of the replacement “like-kind” property must be equal to or greater than the total net sales price of the relinquished property.
- All the equity received from the sale of the relinquished property must be used to acquire the replacement, “like kind” property.
Taxpayers who hold real estate as inventory or who purchase real estate for resale, are considered “dealers.” These properties are not eligible for Section 1031 treatment. However, if a taxpayer is a dealer and also an investor, he or she can use Section 1031 on qualifying properties. Property for personal use will not qualify for Section 1031.
#4: Timing Is Everything
To successfully complete a 1031 exchange, there are several dates that are crucial.
A like-kind exchange does not have to be a simultaneous swap of properties. But you must meet two time limits or the entire gain will be taxable. These limits cannot be extended for any circumstance (except in the case of presidentially declared disasters).
The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties that you propose or intend to buy. The identification must be in writing, signed by you and delivered to a person involved in the exchange, such as the seller of the replacement property or your qualified intermediary. Giving notice to your attorney, real estate agent, accountant or similar persons acting on your behalf in any part of the transactions is not sufficient.
During this Identification Period, replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.
The second time limit is referred to as the Exchange Period. The replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property.
So to successfully complete a 1031 exchange, a taxpayer must identify the replacement property within 45 days of closing and acquire the replacement property within 180 days of closing the sale of the original property.
#5: Both Properties Must Be Held for a Productive Purpose in Business or as an Investment
Both the relinquished property you sell and the replacement property you buy must be held for one of two purposes:
- For active and productive use in a trade or business, or
- As an investment that is either income-generating, such as a rental property, or expected to increase in value, such as vacant land that you intend to sell later for profit.
Property used primarily for personal use, such as your primary residence or a second home, does not qualify for like-kind exchange treatment. A vacation property may qualify for a 1031 exchange, but there are specific rules to follow. For a minimum of two years prior to and after the exchange:
- The property must be rented for a minimum of two weeks to a non-relative.
- You can rent to a relative if it is their primary residence and is rented at a fair market price.
- The property must be used personally for only two weeks or 10% of the time rented.
- You can maintain the property for an unlimited amount of time, but documentation must be kept for these activities.
- Report income from the property on Schedule E of your tax return.
The 1031 exchange is not intended for investors who are in the business of buying distressed properties, rehabbing them and reselling them.
As mentioned, taxpayers who hold real estate as inventory or who purchase real estate for resale are considered “dealers.” These properties are not eligible for Section 1031 treatment. However, if a taxpayer is a dealer and also an investor, he or she can use Section 1031 on qualifying properties. Again, you always need to remember that “personal use” property does not qualify for Section 1031.
#6: Your Gain Is Tax Deferred, but It Is Not Tax Free
Mentioned earlier and very important to remember: When you use a 1031 exchange, you are postponing the tax because you are exchanging one similar asset for another. While that helps your current cash flow, your gain will eventually be taxed when you sell the new property.
There’s a silver lining: There’s no time limit for holding the property. You can defer taxes as long as you still own the property. And you can do another 1031 exchange on the same property down the road and again defer the taxes, as long as you’re exchanging like-kind properties and following all the rules. You don’t even have to sell the property in your lifetime. You can pass it on to your heirs.
A Word of Warning!
A simultaneous swap of one property for another that happens at the same time is rare, simply because it’s near impossible for everything to happen at the same time when you’re talking about two separate transactions as complex as real estate transfers.
In the more common deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction facilitating the exchange of property. To qualify as a Section 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction).
The IRS warns that you should be wary of individuals promoting improper use of like-kind exchanges. Some educational materials and internet sales pitches seem to propose that a vacation home automatically qualifies for the 1031 exchange. You’ll also hear promoters of like-kind exchanges refer to them as “tax-free” exchanges, rather than “tax-deferred” exchanges. And you may even be advised to claim an exchange despite having already taken possession of cash proceeds from a property sale.
Failure to comply with the deadlines and all the rules will likely result in a failed exchange. If you take control of cash or other proceeds before the exchange is complete, the entire transaction of like-kind exchange treatment is disqualified and all gain is immediately taxable. You might even be held liable for penalties and interest on your transactions. I highly recommend you use an expert to do this for you.
A Stress-Free Way to Do a 1031 Exchange
Online real estate platforms have been revolutionizing the way investors buy property. Many of these platforms allow you to buy shares of both commercial and residential property with relatively small minimum required investments.
But what you may not know is that some of these platforms allow you to defer your capital gains taxes when swapping out investments, thanks to a 1031 exchange.
Here’s a list of the real estate platforms we’ve reviewed that offer this feature: