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What Is A 1031 Exchange: Everything You Need to Know

Updated: January 12, 2023

A 1031 exchange is a powerful tool that lets investors defer paying capital gains tax on the sale of an investment property. It does this by reinvesting proceeds into another property of equal or greater value.

The key to a successful 1031 exchange is finding a replacement property that meets all of the requirements set forth by the Internal Revenue Service (IRS). These requirements can be complex. It’s important to consult with a qualified 1031 exchange intermediary before beginning the process.

Here’s what you need to know about 1031 exchanges, including how they work and the benefits they can offer investors.

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    KEY TAKEAWAYS

    • A 1031 exchange is a powerful tool that allows a tax deferral to business and real estate investors. As such, they can defer paying capital gains on the sale of an investment property.
    • The exchange makes this possible by reinvesting proceeds into a similar property.
    • To qualify, investors must follow strict IRS guidelines, including timelines and documentation requirements.
    • 1031 exchanges let you trade up to a more expensive property.
    • You can trade down to up to three less expensive properties with a total equal or greater value.
    • You can exchange multiple properties for a single property with an equal or greater value.
    • A 1031 exchange can be an excellent way to grow your portfolio without having to pay capital gains taxes on the sale of your property.

    What Is a 1031 Exchange?

    A 1031 exchange is also known as a like-kind property exchange or a Starker exchange. It’s a transaction that lets investors defer payment of capital gains tax on an investment property. It works by reinvesting proceeds from the sale into a similar property.

    To qualify for a 1031 exchange, the following conditions you must meet:

    • The properties must be for investment or used in a trade or business.
    • The properties must be exchanged for other property of like-kind. For example, commercial property for commercial property.
    • The exchange property must be identified within 45 days from the sale of the first property.
    • The replacement property must be received within 180 days of the sale of the first property, or by tax return due date.
    • The taxpayer must designate a qualified intermediary to hold the proceeds from the sale and facilitate the exchange.
    • The acquired property must equal or exceed the market value of the sold property.

    If you are thinking about selling an investment property, a 1031 exchange may be a good option for you to consider. By deferring the capital gains taxes, you can reinvest all of the proceeds from the sale into another property instead of paying capital gains taxes. This strategy can increase your returns. 
    It is important to consult with a tax advisor to ensure that you meet all the requirements for a 1031 exchange as well as to determine if it is the best option for your particular situation.

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    What Qualifies as a 1031 Exchange?

    If you’re looking to complete a 1031 exchange, there are certain criteria you must meet for the exchange to be valid. 

    1. Both the relinquished and replacement property must be for investment or business purposes. This means that your primary house or vacation home would not qualify. 
    2. Both properties must be within the United States, and you must exchange them for one another at the same time. This means that you can’t sell your investment property and then use the proceeds to purchase the replacement property at a later date. 
    3. Both the relinquished property and the replacement property must be “like-kind.” Generally, it means that the real properties must be of the same nature or character..

    For example, you could exchange a strip mall for another strip mall or two residential properties for an apartment complex. You couldn’t exchange stocks or bonds for a piece of land—they have to be the same property types.

    If you’re looking to do a 1031 exchange, consult with a qualified tax professional. They’ll help you make sure that your transaction meets all the necessary criteria.

    How Does a 1031 Exchange Work?

    If you wish to defer your capital gains taxes, you have to reinvest the proceeds from the sale of your property into a “like-kind” investment. The like-kind property means that you can exchange investment property that is of similar nature or character  You cannot exchange personal property for real estate or vice versa. 

    Tax code for the section 1031 exchanges governs the specifics of like-kind exchanges. It states that you must designate the replacement property within 45 days of the sale and reinvest the proceeds from your sale into a “like-kind” investment within 180 days. 

    If you do not meet the required time periods, you will be subject to capital gains taxes on the sale of your property.

    When Should a 1031 Exchange Be Used?

    The 1031 exchange is a powerful tool that you can use in various situations to create substantial tax savings. Here are four common scenarios where you should consider using a 1031 exchange:

    1. When you want to trade up to a bigger or better investment property
    2. When you want to sell an investment property and reinvest the proceeds into multiple real estate properties
    3. When you want to diversify your portfolio by exchanging into different types of investment properties
    4. When you want to defer capital gains taxes on the sale of an investment property

    Thanks to the 1031 exchange, you can sell an investment property and reinvest all of the proceeds into another property. You can do this without having to pay any capital gains taxes on the sale.
    This allows you to defer paying taxes on your capital gains until you sell the last property without undergoing another 1031 exchange. At this point, you’ll pay taxes on any appreciation since the last exchange.

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    Rules and Requirements for 1031 Exchanges

    Now that we’ve answered the question, “What is a 1031 exchange?”, it’s important to understand the rules that govern these transactions. Here are the three most important exchange rules to remember:

    1. The exchanged properties must be for real estate investment or used in a trade or business. This means that you can’t exchange your personal house for another property.
    2. The exchanged properties must be a like-kind exchange. This is a broad category that generally includes any type of investment or business real estate, whether it’s improved or unimproved land, office buildings, warehouses, retail space, or equipment.
    3. Time limits are in place. You must identify potential replacement properties within 45 days of the sale of the original property. You also must complete the purchase within 180 days.

    These are the most important rules to remember when considering a 1031 exchange, but there are other important details to be aware of, as well. For example, you must use a qualified intermediary to facilitate the exchange.

    Qualified intermediaries are independent third parties. They hold the proceeds from the sale of your property and then use those funds to purchase the replacement property on your behalf. This ensures that you never actually have control of the money, which would trigger a taxable event.
    1031 exchanges can be complex transactions; however, they offer a powerful way to defer capital gains taxes and reinvest your money into a new property. If you’re considering selling an investment or business property, talk to a tax advisor to see if a 1031 exchange makes sense.

    Types of 1031 Exchanges

    There are four types of 1031 exchanges, which are:

    1. Simultaneous exchange: Both the relinquished property and replacement property close at the same time.
    2. Delayed exchange: You sell the relinquished property first and acquire the replacement property within the set timeframe).
    3. Reverse exchange: The replacement property is acquired first. The relinquished property gets transferred after (again, the 180-day time rule). This type of exchange requires that the acquired property be held in a separate entity, like a separate LLC. You cannot be the owner of both properties at the same time.
    4. Build-to-suit exchange: Like a delayed exchange, but with more specific timing requirements for the acquisition of both properties. The taxpayer identifies potential replacements before selling the relinquished property in this exchange. Once the relinquished property sells, the taxpayer has up to 180 days to purchase one of the identified properties.

    It’s important to understand the different types of 1031 exchanges because each has its own set of rules and regulations. As such, it’s imperative that you choose the exchange designed for your needs.

    Pros and Cons of 1031 Exchange

    Like any investment, there are pros and cons to 1031 Exchanges. Some of the benefits include:

    • Deferring capital gains taxes
    • Reinvesting in a property of equal or greater value
    • Upgrading to a better investment property
    • Diversifying your investment portfolio

    On the other hand, some of the drawbacks include:

    • The need to find a qualified intermediary 
    • The risk of having to pay taxes if the exchange is not completed properly
    • The possibility of having to pay taxes on the difference in value if the replacement property is worth less than the original property

    If you’re thinking of doing a property for exchange, it’s important to weigh the pros and cons carefully to see if it’s the right decision for you.

    Summary

    A 1031 exchange is a powerful tool that allows real estate investors to defer capital gains taxes on the property sale. 1031 exchanges can be used to reinvest in a new property and continue to grow your investment portfolio tax-deferred.

    As with any complex financial transaction, it’s important to work with a qualified intermediary. Be sure to consult with a real estate broker or tax advisor to ensure that your 1031 exchange is done correctly.

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    Frequently Asked Questions About 1031 Exchange

    How Much Does It Cost to Do a 1031 Exchange?

    The costs vary depending on the type and complexity of the exchange. Typically, you will need to hire a qualified intermediary to handle the paperwork and process. You may also need to pay for legal or tax advice.

    How Many Times Can I Do a 1031 Exchange?

    There is no limit to the number of times you can do a 1031 exchange or the frequency.

    What Is an Example of a 1031 Exchange?

    One example of a 1031 exchange is exchanging land rental property for a rental property. Another example is exchanging a small apartment building for a bigger one.

    Which States Do Not Recognize 1031 Exchanges?

    Since it’s a federal tax code, all states recognize 1031 exchanges.

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