Internal Revenue Code §1031 provides real-estate investors with a powerful tool known as a “1031 exchange.” What does it do exactly? It allows investors to hold on to gains they’ve made from their real-estate investments without having to pay taxes on the gains. That’s pretty sweet.
So what’s the catch? Well, you could argue there isn’t one. A 1031 exchange allows investors to reinvest proceeds from a sale into a similar real-estate investment (we also use the term “like-kind”).
The 1031 exchange process has the same kind of reputation as calculus: it’s a lot of work and not always easy to understand. But I’m here to break it down for you. Below are 10 key elements to consider if you think a 1031 exchange might be the right investment tool for you.
- There are limits on the investments that qualify for an exchange
The property you sell and the replacement property you buy must meet certain requirements. Both properties must be “held for use in a trade or business or for investment.” Unfortunately, a property used primarily for personal use, like a primary residence or a second home or vacation home, doesn’t qualify. And, both properties must be similar enough to qualify as "like-kind,” which is a fancy way of saying property of the same nature, character or class. For example, real estate property improved with a residential rental house is like-kind to vacant land.
- How your investment property is held makes a big difference
Certain types of property are specifically excluded from section 1031 treatment. Examples include stock or equity securities in a corporation, partnership interests, LLC interests and certificates of trust are all excluded from Section 1031 eligibility.
- 1031 exchanges are tax deferred, not tax free
We know the words “tax free” sound glorious. But just as there’s no such thing as a free lunch, there is no such thing as a pass on taxes. The basis of property acquired in a Section 1031 exchange is the basis of the property you sell—with some adjustments. When you transfer the basis from one property to another, you preserve the “gain” for recognition later. It’s like you’ve frozen that gain in time.
A collateral effect is that the resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax. This is why it’s so critical to adjust and track basis correctly to ensure you are complying with Section 1031 regulations (or have a trusted professional do that for you).
- But there is some good news, because you can defer taxes forever
Yes, you read that correctly. There is no limit on the number of 1031 exchanges you can do. You can roll the deferred gains on an investment property over and over. With proper estate planning, you can ultimately pass these real estate investments to your heirs. The cumulative deferred gains pass on to the hereafter (just like you), so your heirs receive a step-up in basis and avoid paying all of built-up deferred taxes.
- The size of your property matters
The size or value of the investment (equity) in the replacement property must equal or exceed the net proceeds received from the sale of the property you give up. Any net proceeds you receive that are not reinvested are treated as capital gain for tax purposes.
- The size of your debt matters, too
The value of liabilities you assume with the replacement property (i.e., the mortgage debt) must equal or exceed the value of the liabilities you relieve yourself of when you relinquish your old property.
- Time is of the essence
While a 1031 exchange does not have to be a simultaneous swap of properties, you must meet two time limits or face taxes on your gain. The first time limit: within 45 days of the date you sell your relinquished property you must identify potential replacement properties. The second time limit: you must complete the replacement property exchange transaction no more than 180 days after the sale of the exchanged property, or the due date (with extensions) of the income tax return for the tax year in which your relinquished property was sold, whichever is earlier.
- You can identify multiple replacement properties
You can choose up to three possible replacement properties, though they must be clearly identified in writing. In the case of real estate, this means a legal description, street address or distinguishable name. The notice must be signed and delivered to a person involved in the exchange, either the seller or the qualified intermediary. Notice to your attorney, real estate agent, accountant, or similar persons acting as your agent is not sufficient.
- Don’t touch the cash
Taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make all gain immediately taxable. The best way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete.
- Lastly, be careful about who you work with
Properly executing a 1031 exchange requires dealing with qualified advisors and intermediaries (exchange facilitators). A trusted tax advisor is important for calculating and tracking the taxable basis of your real estate investments throughout the term of investment and all subsequent exchanges, and can help you determine if a replacement property (or investment) qualifies for 1031 exchange tax deferral. And be careful when selecting a qualified intermediary—intermediaries sometimes declare bankruptcy or become otherwise unable to meet their contractual obligations. An error along the way can be very costly in terms of capital gains taxes and depreciation-recapture taxes, or disqualify your transaction from 1031 treatment.
You should be in a better position now to gauge if a 1031 exchange is right for you. Don’t be afraid to ask questions, and to partner with experienced professionals who can help you make the right decision for your overall investment strategy.