A 1031 exchange is a method that taxpayers can use to defer the payment of capital gains when they sell real estate under certain circumstances. For the transaction to succeed, it must involve the exchange of one investment property for another, and the properties must meet the IRS' definition of "like-kind." In addition, there are some other crucial rules governing the process, all of which the taxpayer must follow to avoid disqualification of the deferral:
- The taxpayer cannot have access to the proceeds of the sale of the relinquished asset during the time between the initial sale and the purchase of the replacement property (or properties). For this and other reasons, a 1031 exchange must be administered by a Qualified Intermediary.
- Only investment property or other property used solely for business is eligible for exchange. Assets used for personal purposes or held primarily for sale are not qualified as investments.
- The property sold must be “like-kind” to the replacement property. The IRS limits eligibility to real property, excluding equipment, vehicles, artwork, collectibles, and intellectual property, following the passage of the Tax Cuts and Jobs Act in 2017. However, the IRS has been flexible with applying the use of "like-kind" between types of real estate, allowing swaps between land and developed property, for example, and between office and residential or other sectors. But, again, the investment distinction is key.
Can I Complete a 1031 Exchange for My Primary Residence?
The short answer to this question is a clear no. Since your primary residence is not considered an investment property, you can’t use a 1031 exchange to defer the payment of capital gains taxes if you sell it. However, the good news is that you will have limited liability for the gains realized on a residence in most cases. Single taxpayers are allowed an exemption for the first $250,000 in capital gains for a personal home, while married couples can exempt double that amount. Taxpayers can claim the exemption every two years, but you must have lived in the home for at least two of the last five years (they don’t have to be the most recent two).
There Are Exceptions
However, suppose you own a four-plex and live in one of the four units, renting out the other three. Now the situation is a bit more complex. The unit you live in is a personal residence, and when you sell the property, you can claim the exemption for the capital gain (up to the limit). But the three units that you rent to others (assuming you rent them at fair market value) are investments and can be eligible for 1031 exchange treatment.
Suppose that your cost basis in the property is $1 million, not including the land, and after owning it and living in one unit for three years, you sell the four-plex for $1.4 million. Since you can claim the personal exemption for the gain of $100,000 on the unit that is personal, you would have a capital gain on the investment property portion of $300,000. Therefore, you can consider pursuing a 1031 exchange to obtain replacement property valued at $300,000 (following the 1031 requirements) to defer that tax payment.
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. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. Examples shown are hypothetical and for illustrative purposes only.
