A 1031 exchange is a tool that investors can use to defer the recognition of capital gains when they want to sell one piece of investment property and purchase another. The reference is to the relevant section of the Internal Revenue Code, specifically Title 26, Section 1031. Originally the intention was to allow farmers to exchange parcels of land, but the allowable uses have changed since the exchanges were first permitted in 1921.
If an investor wants to dispose of one investment property and purchase a different one (or more than one) using a 1031 exchange, the incentive to do so might be a deferral of capital gains taxes, depreciation recapture, and Net Investment Income Taxes (aka Affordable Care Act taxes.) The process can also support enhanced variety in the investor's portfolio.
How Does the 1031 Exchange Process Work?
The 1031 exchange process is reasonably straightforward, although investors should be careful not to miss strict IRS deadlines or risk a failed exchange. The clock starts ticking when the initial property sale (referred to as the "relinquished asset" takes place. The investor has 45 calendar days to identify potential replacements, subject to these limits:
- Identify one to three potential replacement properties, with no maximum price (to qualify for the exchange, the price must at least equal the sale price of the relinquished asset);
- Identify as many potential replacements as you want, with a combined value of no more than 200% of the property you are selling; or
- Identify an unlimited number of potential replacements, but ultimately purchase a combination of them that equals 95% or more of the combined value.
The next deadline is for the consummation of the purchase, which must be finished by 180 days after the initial sale, inclusive of the first 45.
What About the Type of Property?
While the rules focus on replacing value (and debt), the IRS does not include details about the type of property that a taxpayer can exchange. Instead, the code language specifies a "like-kind" swap, and the IRS has allowed that most real estate is considered “like-kind” to other real estate. For example, vacant land is deemed like-kind to multi-family development, and ranch acreage is treated as like-kind when swapped for an office building.
The critical requirement is that the property is held for business or investment purposes. So while a residential rental property would typically be eligible, a personal home would not.
How Does an Investor Report the Exchange?
One of the crucial aspects of a successful 1031 exchange is using a Qualified Intermediary to manage the transaction. A QI can be an individual or a company but must be an independent actor not related to the investor or an agent thereof. The QI is responsible for overseeing the transaction, particularly ensuring that the taxpayer does not have access to the proceeds from the original asset sale and tracking the acquisition of the identified replacement properties.
The details of a 1031 exchange, including the property descriptions, dates and property values, gains or losses, and other relevant information, are captured and reported to the IRS on Form 8824 "Like-Kind Exchanges." Taxpayers should always seek the advice of a financial and tax professional.