Property investors make money through rental income or by selling property. Any gains are subject to being taxed.
One loophole property investors can take advantage of when they sell investment property is a 1031 property exchange. This allows you to use the gains from the sale of one investment property to immediately buy another investment property, without paying taxes on those gains.
Learn how a 1031 property exchange works and how it may lower your tax burden.
What Is a 1031 Property Exchange?
A 1031 exchange allows a property investor to swap one property for another. When you sell a property, you roll over any gains from that property into the purchase of a new property.
When you perform a 1031 property exchange, you are using any gains to purchase the new property. This means you defer paying taxes on any capital gains from selling a property.
If you also receive other, not like-kind property or money as part of the exchange, the other property and money you receive are recognized as a gain. Loss is not recognized.
The new property must be a like-kind property, meaning you are replacing one type of investment with a similar type of investment. For example, if you sell a multi-family property, you can buy any other type of real estate that is considered an investment, such as another multi-family, a retail property, a condo, or a plot of land.
With a 1031 exchange, you are able to immediately unload property you no longer want and purchase something new with the full amount of your gains, instead of having to pay taxes on the gains first and then using whatever is left to buy another property. It gives you more purchasing power.
A 1031 exchange can be done with property that is used for investment or for business. It cannot be done with personal residences.
How a 1031 Property Exchange Works
In a 1031 exchange, you cannot personally hold onto any money you made from the sale of the first property. According to the IRS, this money must be held by a qualified intermediary until it is used to purchase the replacement property.
An example of a qualified intermediary would be a title agent, who would assign and transfer title from the old property and assign and transfer title for the new property. This prevents you from taking control of the proceeds (cash or otherwise) before the exchange is complete, which could disqualify the exchange from 1031 status and make it fully taxable.
A 1031 exchange must be done quickly. You do not have long to identify and close on a replacement property.
Within 45 days of selling your current property, you must identify the property or properties you wish to purchase during the exchange. By the end of that window, you must identify the property, or properties, in writing. You must include:
- Physical description of the property
- Legal description of the property
- The property address
This document must then be signed and delivered, usually to the qualified intermediary who is holding the gains from the first property. It could also be delivered to:
- The seller of the replacement property
- An escrow agent
- Another person who is involved in the exchange
There are two options when it comes to identifying replacement property.
- Three Property Rule: You can identify a maximum of three potential replacement properties. In this case, it does not matter what the fair market value of the properties are.
- Two Hundred Percent Rule: In this approach, there is not a maximum number of properties that you can identify. Instead, the total fair market value of the properties that you identify cannot be more than 200% of the fair market value of the properties that you sold at the time of the sale.
You also have a limited window of only 180 days from the sale of your current property to close on the replacement property or properties.
You must report like-kind exchanges to the IRS on Form 8824.
Requirements for a 1031 Property Exchange
To qualify for a 1031 property exchange, three criteria must be met:
- The investment property that you purchase must be of equal or greater value than your current property.
- You must use any gains from the previous property sale to purchase the new property.
- The new property must be considered a like-kind investment.
The IRS does not set any limit on the number of 1031 exchanges an individual can do. As long as you are selling a property and then reinvesting the profit from that property into another similar investment, you can do a 1031 exchange and put off any tax consequences.
However, if you are doing a large number of 1031 exchanges, you could become classified as a dealer and your properties would be looked at more like stocks that are being traded. In this case, you would have to prove that you are using these properties as investments in order to continue doing 1031 exchanges.
Types of 1031 Property Exchanges
Under the Tax Cuts and Jobs Act (TCJA, also known as the Trump Tax Cuts), Section 1031 can only apply to real property. You cannot do a 1031 property exchange with intangible or personal property, including:
- Machinery, vehicles, or other equipment
- Patents and other intellectual property
- Stocks or bonds
- Other securities or debt
- Certificates of trust
- Partnership interests
- Other intangible business property
Real property in the United States is also not considered like-kind to real property outside the United States. Section 1031 property exchanges must take place with property held in the United States.
- A 1031 property exchange allows you to use the gains from the sale of one investment property to immediately buy another investment property, without paying taxes on those gains.
- The new property must be a like-kind property, meaning you are replacing one type of investment with a similar type of investment.
- You cannot personally hold onto any money you made from the sale of the first property. This money must be held by a qualified intermediary until it is used to purchase the replacement property.
- A 1031 property exchange cannot be used for intangible or personal property.