A 1031 exchange is a tool investors can use to buy and sell real property assets while deferring the need to pay capital gains taxes on the profits. All property relinquished and acquired using a 1031 exchange must be held for investment purposes to qualify. Here is an example of how the process works:
The investor owns property they have held as an investment for several years, which has increased in value from $200,000 when purchased to $400,000. For example, suppose the property is an office building, and the owner wants to change his focus to single-family rentals. Then investor employs a Qualified Intermediary (QI) to manage the 1031 exchange. Hiring this administrator is a crucial part of the process and helps increase the probability of executing a successful exchange.
The investor sells the targeted property, and the QI takes control of the proceeds. For a 1031 exchange to succeed, the replacement property or properties must have at least as much value as the property sold. The investor identifies potential preplacement assets and informs the QI. The QI oversees the acquisition(s) and manages all necessary documentation.
Using a 1031 exchange can potentially allow the investor to defer the capital gains taxes sequentially on later exchanges. If, at any time, the investor sells the current exchange property without completing another exchange, all deferred taxes are due. The exception is if the investor distributes the final property to an heir upon death. In that case, the heir receives the property at the current fair market value, and prior deferred taxes are eliminated.
The IRS will allow almost any exchange of qualified property held for investment. For example, you can swap a hotel for a solar farm, a retail center for an apartment complex, or a single-family residence in one area for a single-family residence in another area. Any investment property will likely qualify as a “like-kind” swap for another. However, it’s crucial that the replacement property be an investment.
Things change, and people may alter their plans for a particular asset. For example, if an investor decides to transform their rental property into their primary residence, they can do so if they follow the rules. The primary stipulation from the IRS is that the investor must maintain the property as a rental for at least two years following the exchange. The IRS requires that time period as evidence that the investor intended to acquire the property for use as a rental rather than with the intent to live there.
For an owner to demonstrate the status of the acquired asset as an investment, the owner needs to rent it to others at fair market value during the two years following the acquisition. The rental must be at least 14 days yearly, and the investor must show rental income on their tax return. However, the owner may also use the property on a limited basis. The usage restrictions limit the personal occupancy to either 14 days each year or ten percent of the total days the property was rented out, whichever is higher.