FAQ on 1031 Exchanges
From start to finish, 1031 exchanges are complex transactions. There are rules, deadlines, property restrictions, and convoluted terminology to navigate.
That’s why we rounded up a few of the most frequently asked questions (FAQs) about 1031 exchanges to help start you down the right path on the road to real estate success.
1031 exchanges can apply to properties outside of real estate, but these FAQs focus on the details of 1031s related to real estate.
What is a 1031 exchange?
A 1031 exchange is an IRS-authorized exchange of properties without immediate tax liability.
The name “1031 exchange” is short for Section 1031 of the U.S. Internal Revenue Service’s tax code. This section states that if an individual exchanges one investment property for another, they may be able to defer any capital gains or losses made on the sale of the initial property by reinvesting in a similar property.
Does this mean 1031 exchanges are tax-free?
No. Exchanges done properly mean that capital gains and losses are tax deferred. This means the capital gains are tax-free until the investor takes possession of them. It’s also important to know that taking control of cash or other proceeds before the exchange is complete may make all gains immediately taxable.
You must report an exchange to the IRS and file it with your tax return for the year in which the exchange occurred usingForm 8824.
Who qualifies for a 1031 exchange?
The IRS says:
“Owners of investment and business property, individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties.”
How do I know I have the right properties for a 1031 exchange?
First things first, you must own the property you are selling. And according to the IRS, both properties must be “like-kind.”
“Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.”
It’s important not to be fooled by this seemingly clear definition of “like-kind.” It can mean a lot of different things for a lot of different properties.
Are there properties that cannot be used in a 1031 exchange?
Yes. The following properties cannot be used in a 1031 exchange: vacation homes that are not used as rental properties, primary residences, and property located in a foreign country.
Are there different types of 1031 exchanges?
Yes, there are four different types of 1031 exchanges:
- A deferred exchange allows investors to defer capital gains or losses they would otherwise have to pay at time of sale and use it to purchase more real estate in the future. This is the most common type of exchange.
- A reverse exchange is a strategy investors use to purchase property first and sell property second. This allows investors to capitalize on market opportunities.
- A simultaneous exchange closes the relinquished property and the replacement property on the same day, without any interval of time between the two closings.
- An improvement exchange is an exchange in which an investor arranges for improvements to be made on the replacement property prior to receiving it in the exchange.
What rules should I be aware of?
There are a lot of rules to follow to successfully execute a 1031 exchange. Some of the most pertinent include:
- You can only perform a 1031 exchange between investment properties.
- If you exchange for a cheaper property, there will be tax considerations around the price difference.
- You can “delay” your exchange (which most people do), by involving a third party who acts as an intermediary to facilitate your exchange of like-kind properties.
- Neither you nor your agent—including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years—can act as your facilitator.
What deadlines apply to 1031 exchanges?
Once you identify a property, you need to complete the exchange within 180 days after the sale.
How many times can I do a 1031 exchange?
There is no limit to how often or how frequently investors may perform 1031 exchanges.
Are there professionals who can help me through the process?
Yes, these are commonly known as “1031 Accommodators”
It’s important to know whom you are hiring to help facilitate your 1031 exchange. The IRS warns against schemes:
“Taxpayers should be wary of individuals promoting improper use of like-kind exchanges. Typically they are not tax professionals. Sales pitches may encourage taxpayers to exchange non-qualifying vacation or second homes. Many promoters of like-kind exchanges refer to them as ‘tax-free’ exchanges not ‘tax-deferred’ exchanges. Taxpayers may also be advised to claim an exchange despite the fact that they have taken possession of cash proceeds from the sale.”
Think a 1031 exchange may be in your future? Read more about them on our blog: