A 1031 exchange is defined under section 1031 of the IRS code, and it’s a strategy used by taxpayers to defer capital gains taxes on a business or investment property. Upon the sale of the property, the taxpayer must find and purchase a “like-kind” replacement property with the profit gained from the sale of the relinquished property within a strict time period dictated by the IRS.
If you plan accordingly with your qualified intermediary and follow IRS rules and guidelines, a 1031 exchange can be a powerful investment strategy.
To qualify for a tax-deferred exchange under IRC Section 1031, there are certain rules to abide by:
- Like-kind property: Qualifying properties are considered to be “like-kind,” meaning that they are real property, within the U.S., of the same nature or character, even if they differ in grade or quality. For example, you cannot exchange an apartment building for construction equipment, but you can exchange that same building for raw land.
- Taxpayer intent: The taxpayer’s intent to hold the relinquished and replacement properties must be for business or investment purposes. Personal property does not qualify for a tax-deferred exchange.
- Value must be greater or equal: The net value and equity of the purchased property must be greater than or equal to the relinquished property.
- Taxpayer must not receive boot: Any boot received by the taxpayer is taxable to the extent of the gain realized on the property. It’s okay to exchange into a property of lesser value, but there will be tax consequences.
- Same taxpayer: The name of the taxpayer on the title and tax return of the relinquished property must be the same as the tax return and titleholder buying the replacement property. The exception to this rule is in the case of a single-member LLC. A single-member LLC can sell a property and purchase the replacement in their individual name.
- 45-day identification period: After closing on the first property, the taxpayer has a 45-day identification period to identify three potential replacement properties. An exception is the 200% rule, where the taxpayer can identify four or more properties as long as the value does not exceed 200% of the sold property.
- 180-day exchange period: The taxpayer has a 180-day exchange period from the closing date on the first property to the acquisition of the replacement property.
What Properties Don't Qualify?
As we explained above, the relinquished and replacement properties must be like-kind and held for business or investment purposes. The IRS specifically excludes these types of properties from tax-deferment:
- Inventory or stock in trade
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Certificates of trust
What Do You Get?
If you played your cards right, you could postpone your long-term capital gains by doing a 1031 exchange on your business or investment property, giving you financial leverage. Keep in mind, 1031 exchanges are not for tax avoidance. Tax is recognized when the taxpayer sells for cash instead of exchanging for another property. You can exchange as often and for as long as needed to defer capital gains tax.