When you go to sell an investment property, you may be required to pay taxes on any capital gains from the transaction. Taxes are a drag on any investment; they reduce returns, and the amount of money you can apply to new investments. However, real estate investors have a tool at their disposal for deferring capital gains taxes — it’s called a 1031 Exchange.
IRS Code 1031 allows investors to sell a property and use the proceeds to buy another property while deferring federal and state taxes on gains, as well as depreciation recapture taxes (i.e., the property sold for more than its depreciated value). The end result is that you have more cash to invest in a new property.
There are a few rules to follow to make sure that you qualify for a 1031 Exchange.
Property Requirements
When utilizing a 1031 Exchange, the property being sold must have been held for productive use in a trade, business, or investment. Personal property, such as your house, doesn’t qualify for a 1031 Exchange.
The IRS says that the property must be any real property. While that definition is a bit vague, there are a few examples to help us out:
- Apartments
- Vacant lots
- Single-family homes
- Vacant land for a commercial building
The property must be exchanged for “like-kind” property. What is “like-kind,” you ask? It is an income-producing or investment property in the United States. The following examples are valid exchanges:
- Apartment for a single-family home
- Ranch for an office building
- Industrial property for residential property
- Vacant land for a commercial building
An example of two properties that can’t be exchanged is real estate for artwork since they are not “like-kind.”
Under certain IRS safe-harbors, you can also 1031 exchange a rented out old residence that you’ve held for at least two years. These safe harbors are not restricted to real estate. For example, farmers can 1031 exchange tractors or even cows.
Taxpayer Requirements
Certain entities are eligible for a 1031 exchange:
- Individuals
- C-corps
- S-corps
- Partnerships (general or limited)
- LLCs
- Trusts
- Any other taxpaying entity
The entity cannot receive a constructive receipt of funds from the sale of the relinquished property.
Once your property is sold, its gains are taxable. To defer taxes, another party called a Qualified Intermediary (QI) must be used. A QI, also called an Accommodator or Facilitator, facilitates the 1031 Exchange. The property being sold and the one being acquired both go through the QI. Think of the QI as an escrow. The QI also ensures the correct documents are used and that the 1031 Exchange process is executed according to IRS rules.
QIs are not regulated, so you’ll want to take your time in choosing one. There is a QI national trade association called the Federation of Exchange Accommodators, which might provide some help in finding a credible QI.
There are restrictions on time frames for identifying and acquiring the new property. Once the old property has been sold, the replacement property must be identified within 45 days. Then the new property must be purchased within 180 days of selling the old property.
You aren’t restricted to identifying just one property with the 45-day timeframe. You’re allowed to identify up to three properties. These replacement properties must be of equal or greater value than the property being sold.
Conclusion
1031 Exchanges are common among real estate investors and are a well-known process for deferring capital gains taxes. The advantage of tax deferral certainly makes them well worth the effort. With a 1031 Exchange, you’ll have more capital available to deploy to your next investment property. As long as you meet the 1031 qualifications and use a QI to execute the process, the exchange is generally straight-forward.
