What Is a 1031 Property Exchange?

Swapping Property to Defer Taxes

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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 exchange. Learn what a 1031 exchange is and how it may help lessen your tax burden.

What Is a 1031 Exchange?

A 1031 exchange basically allows a property investor to swap one property for another. The idea is that, when you sell a property, you roll over any gains from that property into the purchase of a new property.

Since you are using any gains to purchase the new property, you are not realizing the gains, so you do not have to immediately pay any taxes on this money. You defer paying taxes until you sell the new property, unless you do another 1031 exchange.

Qualifying for a 1031 Exchange

To qualify for a 1031 exchange,three criteria must be met:

  1. The investment property that you purchase must be of equal or greater value than your current property.
  2. You must use any gains from the previous property sale to purchase the new property.
  3. The new property must be considered a “like-kind” investment.

What Is Like-Kind Property?

Like-kind simply means replacing one type of investment with a similar type of investment. It does not have to be the exact same type of property, it just has to be an investment property. 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.

Can Any Property Owner Do a 1031 Exchange?

A 1031 exchange can be done with property that is used for investment or for business. It cannot be done with personal residences.

Benefits of a 1031 Exchange

The main reason to do a 1031 exchange is to defer paying taxes on any capital gains from selling a property. 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 property. It gives you more purchasing power.

Who Holds the Money Until Purchase?

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. To understand the complete definition of who the IRS considers a qualified intermediary, please see § 1.1031(k)-1(g)(4) of the treasury regulations.

Short Window to Purchase New Property

One downfall of doing a 1031 exchange is how quickly it must be done. You do not have long to identify and close on replacement property.

  • 45 Days:
    • During a 1031 exchange, you have a 45 day identification period. Within 45 days of selling your current property, you must identify the property or properties you wish to purchase during the exchange.
  • 180 Days:
    • You have 180 days from the sale of your current property to close on the replacement property or properties.

Rules for Identifying Replacement Property

  • Put It in Writing:
    • Identify- For a property to be considered as a replacement property, you must identify the property, or properties, in writing by the end of the 45th day. You must include:
      • A physical description of the property.
      • A legal description of the property.
      • The property address.
    • Sign- You must sign this document.
    • Deliver- It is usually delivered to the same person, 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.
  • How Many Properties?:
    • There are two options when it comes to identifying replacement property.
      • 1. 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.
      • 2.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 percent of the fair market value of the properties that you sold at the time of the sale.

How Many Times Can You Do a 1031 Exchange?

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.