How Do 1031 Exchanges Work?

Posted by Clay Schmidt on Sep 28, 2020


In the simplest terms, a 1031 Exchange allows a taxpayer to defer the recognition of capital gains tax due from the sale of investment property by replacing the sold property with a "like-kind" property of the same or greater value. Section 1031 of the Internal Revenue Code originally applied to personal property as well as real estate, but was amended by the Tax Cuts and Jobs Act to remove exchanges of intangible and personal property. To successfully defer the capital gain, the taxpayer must use the profit from the sale to purchase a like-kind property within 180 days.

Initially, the exchange was an actual swap of property, taking place in real-time. This is still a possible scenario, although unusual, since it may be challenging to identify a property owner that has the property you wish to purchase and who also wants to acquire the property you are seeking to relinquish. A delayed exchange is far more common. In a delayed exchange, the taxpayer sells the identified property, and an intermediary holds the funds realized. The money realized from the sale must never go into your bank account, and the intermediary can't be related to you or employed by you. The seller has 45 days to identify the replacement property and 180 days to finalize the replacement transaction. These limits were imposed by the Deficit Reduction Act of 1984 in response to the U.S. Ninth Circuit Ruling in the case of Starker v. United States.

What kinds of property qualify under Section 1031?

The essential requirement for exchange in a 1031 is that the properties are "like-kind," but this is not well-defined and not strictly interpreted. Keep in mind that the deal is only allowed for investment and business properties—you are not allowed to swap a business property for a primary residence or a home for a commercial property. But within the commercial real estate portfolio, there is room for creativity. You can exchange a retail space for a vacation rental, or a commercial office tower for a single-family rental complex. One property can be improved while the replacement is unimproved. The properties can be of different grades or quality levels if they are the same nature, and the rules allow for multiple properties to replace a single asset or vice versa. Both relinquished and acquired properties must be within the United States.

What is the advantage of the swap?

The significant benefit to the investor is the ability to change the focus of your investments without recognizing any capital gains. For example, suppose you have a rental property that has appreciated but has reached a point at which it will require a capital infusion, but your strategy is to pursue current income. In that case, you may want to consider an exchange of that asset for like-kind property. If you're going to shift from commercial buildings to single-family properties, a series of 1031 exchanges will allow you to overhaul your property portfolio's focus without paying taxes on the gains you may have achieved over time. It is important to note that if the replacement property costs less than the relinquished property, you will pay capital gains on the uncommitted excess, or "boot." The transaction costs, such as commissions, inspections, and fees, are included in the overall price.

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.

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