What to Know about 1031 Exchange Restrictions

The 1031 exchange—also called the “like-kind” exchange—allows investors to “swap” a real estate property for another of equal or greater value. When performed correctly, the process can help investors defer capital gains and depreciation recapture taxes generated by the property’s sale.

However, not every real estate asset is eligible for 1031 exchange treatment. Knowing the restrictions and prohibitions ahead of time can help avoid an unexpected tax bill on your next return.

Key restrictions of the 1031 exchange include the following.

The Property’s Purpose

One like-kind restriction is that the property in question must be used for business and/or investment purposes. You can’t use the house in which you live or your secondary vacation home to generate a 1031 exchange.

However, there is an exception to this rule. That personal property might be eligible for a like-kind exchange if you:

• Own the property for at least 24 months, AND
• You rent the property at a fair market price for at least 14 days per year AND
• Your personal use doesn’t exceed either the 14 days or 10% of total days rented per year, whichever is greater

The Property’s Type

One misconception is that the like-kind exchange means that the relinquished and replacement properties must be identical. In other words, if your relinquished property is a duplex, the replacement property must also be a duplex.

This isn’t the case. “Like-kind” means you can swap real estate for real estate as long as the targeted real estate is of equal or greater value than what you sell.

But only real estate assets are eligible for a 1031 exchange. Property that is prohibited from the process includes:

• Stocks, bonds or notes
• Partnership interests
• Certificates of trust
• Inventory property used and acquired for resale
• Equipment
• Stamp, coin, art, or wine collections

At one time, personal and intangible assets that generated capital gains when sold were eligible for the like-kind exchange. However, the Tax Cuts and Jobs Act of 2017 narrowed the definition of eligible 1031 exchange assets to real property only.

The Property’s Strategy

As mentioned above, real estate used for investment and business purposes is eligible for a 1031 exchange. Properties explicitly held for sale are not. These assets include:

• Homes that are bought, renovated and immediately sold (i.e., “flipping”)
• Homes developed specifically for sale

In the above cases, the properties are considered inventory rather than investments and are not permitted as part of a 1031 exchange process.

The Property’s Location

U.S.-based real estate can be exchanged only for other U.S.-based real estate.

You can’t sell a retail center in Florida, use the proceeds to buy an apartment complex in Mexico, and hope to defer taxes. The same holds if you sell a warehouse in Canada and use the proceeds to buy a duplex in Maine.

It is possible to replace relinquished international real estate with replacement international real estate. However, you can’t exchange U.S.-based real estate for foreign real estate or vice versa.

Know Before You Go

The 1031 exchange can help you generate a solid tax strategy while growing your investment real estate portfolio. Before proceeding with the process, it’s essential to understand the rules and regulations involved, including the property eligible for an exchange.

Also, be sure to work with a professional who is well-versed in 1031 exchanges so that the process fits your investment and tax strategies.

The tax and estate planning information offered by the advisor is general in nature.  It is provided for informational purposes only and should not be construed as legal or tax advice.  Always consult an attorney or tax professional regarding your specific legal or tax situation.