What is a 1031 Exchange?

Understanding the 1031 Exchange Process

A crucial concept in property management and investment strategies is the 1031 exchange, also known as a Tax Deferred Exchange. The Internal Revenue Code (IRC) Section 1031 defines a 1031 exchange as a real estate investment tool that enables taxpayers to defer capital gains taxes by swapping one investment for another.

Essential Guidelines for Executing a Tax Deferred Exchange

For a 1031 exchange to become valid, the following IRS rules must be met:

• Investors must hold the exchanged property for investment or business trade use.
• Investors must exchange the property for another of like-kind.
• Investors must complete the real estate transaction within 180 days from selling the original property.
• A qualified intermediary must complete the exchange.
• The two parties involved in the exchange must not be related to one another.
• The buyer must purchase a property of equal or greater value than the original property.

How the Exchange Affects the Buyer

A 1031 exchange structures slightly differently than a typical real estate purchase. Firstly, buyers who have sold their original property cannot hold the proceeds for their purchase. Instead, they must hire a qualified intermediary, a third-party agent, to hold the proceeds that will be used to buy the property from the seller.

How the Exchange Affects the Seller

If a seller is selling a property used for investment or business purposes, they may be able to defer the capital gains taxes by re-investing the proceeds into another like-kind property. They have 45 days to identify a replacement property and 180 days to complete the purchase.

Examples

Here are a few examples of how a 1031 exchange can be used:

Example 1:  An investor owns a rental property they want to sell. The property has been owned for two years and has a basis (cost) of $100,000. The property is sold for $200,000. The investor would like to purchase a new investment property.

The investor finds a property they want to purchase for $300,000. Using the 1031 exchange, the investor can sell the rental property and buy a new one without paying capital gains taxes on the $100,000 profit.

Example 2: An investor sells a rental property for $200,000 and uses all the proceeds to purchase a new rental property. The 1031 exchange allows investors to defer capital gains taxes on the $200,000 profit from selling their original property.

What Happens When You Sell a 1031 Exchange Property?

When you sell a property purchased through a 1031 exchange, you must pay capital gains taxes on the sale. This is because the exchange only defers the taxes; it does not exempt you from them forever. However, you will be able to defer paying taxes on the sale if you re-invest the proceeds into a new investment property.

What is a Reverse 1031 Exchange?

In a reverse 1031 exchange, an investor acquires a property before they sell another one. It could be used if an investor wants to purchase a property but does not have a suitable property to sell first.