The 1031 exchange is a tool that investors seek to use to help manage capital gains tax liability by reinvesting the proceeds from the sale of investment property into like-kind assets. The name "1031 exchange" comes from the relevant section of the Internal Revenue Code. Originally it referred to an exchange of actual farmland, but today it applies to taxpayers who hold real property for investment.
What Is the Goal of a 1031 Exchange?
For some investors, the desire to sell and reinvest for various reasons (including to change sectors or geographic concentrations) is outweighed by the disincentive of paying capital gains taxes on appreciation a property has earned. While capital gains are taxed at a lower percentage than ordinary income for most investors, not paying taxes is still considered better than paying, no matter the rate.
A 1031 exchange offers taxpayers a way to defer the payment of capital gains taxes on those gains while reinvesting the funds into other investments. While the critical term here is "defer," not "eliminate,"; with proper execution, the investor can continue the deferral exchange process indefinitely (until they bequeath them to their heirs, who then benefit from the step-up in basis that accompanies the inheritance).
A 1031 Exchange Is Complicated
The rules governing the process are strict, including adherence to specific timelines and the need for arm's-length transactions. As a result, an investor must have expert guidance to avoid failure to comply with one or more of the critical requirements of the 1031 rules. Some of the potential pitfalls to watch out for include these:
Like-kind property. As referenced in the title question, a single-family home could be the replacement property in an exchange in which the relinquished asset is a multi-family home. The IRS has been flexible regarding the application of the "like-kind" provision. In each case, the assets exchanged must be held for investment or used for business. That means neither the single-family nor multi-family dwelling can be a personal residence. Similarly, the investor can exchange retail buildings for office properties or self-storage facilities for medical operations.
Purchase price and debt. The cost of the replacement property (or properties) must be at least as much as the sale price of the relinquished property. If the investor purchases assets for less than the amount for which they sell the relinquished property, they can only achieve a partial deferral of the gain. Similarly, the mortgage held on the new properties must be of the same or larger amount as any mortgage paid off when they sold the relinquished property.
Qualified Intermediary. To assure the successful completion of the 1031 exchange, the taxpayer may not have constructive access to the funds from the original property sale at any time. Instead, they must employ the service of a Qualified Intermediary to manage the sale, hold the funds, and administer the purchase of the replacement property or properties. The investor reports the identification of potential replacement properties to the QI in compliance with the established timeline (45 days from the sale of the relinquished property), and the QI completes the purchase of the targeted asset as directed and within the 180 days allowed by the code (inclusive of the first 45 days).
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits.