Whether you're a first-time investor or a seasoned property owner, a 1031 exchange can impact your tax strategy significantly. With this type of transaction, real estate investors who sell property can defer capital gains taxes by reinvesting proceeds from the sold property into a new property.
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Normally, when you sell investment property, you're required to pay capital gains tax on the profit. But with a 1031 tax-deferred exchange (also known as a “like-kind exchange”), you can delay payment of the tax on the sale of real property (your “original” property) if you use the proceeds from the sale to buy another property (“replacement” property) of “like kind.”
The IRS's definition of a “like-kind” property is broad. Basically, both the original and replacement properties must be used in a trade or business or held for investment. But beyond that, they can differ in grade, quality, and type. For example, you can exchange an apartment building for an office building, or undeveloped land for a warehouse.
The new property also doesn't have to be identical in value to the one you're selling. However, to delay all capital gains taxes, the replacement property should be of equal or greater value. If it's less, you might have to pay taxes on the difference.
Completing a 1031 exchange requires careful planning and attention to detail. Since the process can be complicated, it’s wise to consult a tax professional. But for a general understanding of how a 1031 exchange works, here’s a brief description of the steps involved in a typical like-kind exchange.
Identifying the property you want to sell is a good place to start. This should be an investment property you own that would trigger a capital gain tax if sold without going through a 1031 exchange.
When selecting a replacement property for a 1031 exchange, you should consider the property’s location. For example, if the replacement property is in a different state, you’ll want to review the tax rules in both the selling and buying locations to avoid unexpected state tax consequences. Also note that property in the U.S. and property outside the U.S. are not considered “like-kind” property.
A qualified intermediary, also known as an exchange facilitator, plays an important role in a 1031 exchange. The qualified intermediary holds the proceeds from the sale of your original property and ensures they're used to purchase the new property. Make sure you choose an experienced and reliable qualified intermediary, since they'll be handling critical aspects of the exchange. The qualified intermediary can’t be a relative or anyone that you’ve had a formal relationship with (e.g., as an agent, broker, accountant, attorney, or employee) within a two-year period before the exchange.
The goal in a 1031 exchange is often to defer all capital gains taxes. To achieve this, you should use all the proceeds from the sale of your original property to purchase the replacement property. If you only use part of the proceeds, the remaining funds are taxed right away.
There are a few different types of 1031 exchanges. Each one has its own unique considerations, benefits, and requirements. Which one is best for you depends on your investment needs and timeline.
A deferred exchange is the most common type of 1031 exchange (it’s sometimes called a “Starker” or delayed exchange). With this type of exchange, you sell the original property before buying the replacement property. However, the transaction must be an exchange of property for property, not a transfer of property for money used to buy the replacement property.
To complete a deferred 1031 exchange, you must identify the replacement property within 45 days after selling the original property. You then have an additional 135 days (for a total of 180 days from the original sale date) to actually purchase the replacement property.
A simultaneous exchange happens when the sale of the original property and purchase of the replacement property happen at the same time. It's the most straightforward form of a 1031 exchange, but coordinating both the sale and purchase to happen on the same day can be difficult.
A reverse exchange involves purchasing the replacement property before selling the original one. In this case, a qualified intermediary holds the replacement property once it’s purchased. From that point, you have 45 days to identify the property you want to sell, which must be sold within 180 days of the replacement property's purchase.
Also known as a construction or build-to-suit exchange, an improvement exchange lets you use proceeds from the sale of the original property to improve the replacement property. This might be a good option if you can’t find a like-kind property that meets your current needs. However, you must complete the improvements within 180 days from the sale of the original property.
A 1031 exchange can also delay payment of the net investment income tax. This additional tax only kicks in if you make a certain amount of money, and it adds an extra 3.8% tax on investment income (e,g., interest, dividend income, rental income, etc.) and profits from selling investment property like real estate.
There can be many twists and turns involved with a 1031 exchange. As a result, there are several special rules to cover certain transactions and situations. Here are a few of the more common special rules you should be aware of before entering into a like-kind exchange.
Generally, when you sell depreciable real property, previously claimed depreciation deductions are “recaptured” and taxed (i.e., you have to pay back the deductions). But with a 1031 exchange, you can defer the recapture tax (along with the capital gains tax) by transferring the cost basis from the original property to the replacement property. In essence, you’ll calculate depreciation on the replacement property based on the original property's schedule.
However, to fully avoid depreciation recapture following a 1031 exchange, the replacement property must also be subject to depreciation (e.g., it can’t be undeveloped land). It must also be of equal or greater value, and you need to continue using it in a trade or business or for investment purposes.
Special rules apply to 1031 exchanges between family members to make sure these property swaps aren’t simply arranged to avoid taxes. If you exchange properties with a family member, you both need to hold the properties involved for at least two years after the trade. Otherwise, any tax deferral will be canceled as of the date one of the exchanged properties is disposed of by either you or your relative.
There are a few exceptions to the two-year rule for 1031 exchanges between relatives. Taxes can still be deferred if one of the properties is sold or otherwise disposed of by either party if any of the following applies:
Since both properties involved in a 1031 exchange must be held for use in a trade or business or for investment, a primary residence (i.e., your main home) generally isn’t considered “like-kind” property. However, special IRS rules exist that basically permit you to treat houses and other dwelling units as if they’re held for business or investment purposes. These rules (1) allow a vacation home to be exchanged for a replacement property (including a different second home), and/or (2) let you eventually move into a replacement property.
For a vacation home or other dwelling unit to qualify as an original property in a 1031 exchange, you must have owned the property for at least two years before the exchange, and for each of those years both of the following requirements must be satisfied:
The rules are similar if you want to move into a replacement property and use it as your primary residence. In that case, you must own the replacement property for at least two years before moving in, and for each of those years both of the following must be true:
It's important to remember that a 1031 exchange only delays taxes; it doesn’t eliminate them. A tax bill eventually comes due if you sell the replacement property and don’t reinvest the proceeds into a new property with another 1031 exchange. The original property’s basis generally transfers to the replacement property for purposes of calculating the tax due.
As noted earlier, failing to invest all the proceeds from the sale of your original property in replacement property can also trigger taxes on the unused proceeds.
Other situations can lead to a tax bill, too. For instance, tax may be due if you convert the replacement property to your primary residence without following the rules outlined above or otherwise fail to use the property for investment or business purposes.
If you inherit replacement property after the owner dies, the property’s basis is “stepped up” (increased) to the property’s fair market value at the time of the owner's death. Since taxable gain following the sale of property is generally determined by subtracting the property’s basis from the sales price, you could theoretically sell the inherited property right away for fair market value without having any taxable gain, since the property’s basis would be equal to the sales price. This can reduce or even eliminate the deferred capital gains tax that was postponed through a 1031 exchange.
As a result, incorporating replacement properties into your estate plan is a common strategy for real estate investors. But it’s important to consult with an estate planning professional to make sure all the legal boxes are checked and that a 1031 exchange aligns with your overall estate planning goals.
After completing a 1031 exchange, you must report the transaction to the IRS using Form 8824 to maintain the transaction’s tax-deferred status. You must file the form with your annual income tax return for the year in which the exchange was completed.
Form 8824 asks for details about the properties exchanged, dates of the relevant transactions, fair market values for the related properties, any cash received or paid, realized gain or (loss), related parties, and more. Keep all related documents (e,g., contracts, closing statements, and intermediary arrangements), since these will be necessary to complete Form 8824 accurately.
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