What is a 1031 Exchange?

Despite its name, it is not a transaction completed on Halloween! A 1031 exchange refers to a real estate transaction in which a person takes advantage of Section 1031 of the IRS tax code to defer capital gains tax on appreciated property. How does it work? The capital gains tax is permitted to be deferred if the taxpayer invests the entire proceeds from the sale of one property (relinquished property) into the purchase of a qualifying “like-kind” property (replacement property) within a certain time frame.

It’s important to note that a 1031 exchange is a tool used for business and investment properties only, not personal residences or second homes. Gains on the sale of your primary residence are excluded up to $250,000 (or $500,000 if married filing joint) – so long as it meets the eligibility test. For property to qualify for a 1031 or “Like-Kind” exchange, the replacement property must have the same nature, character or class as the relinquished property.

Also important to note is that the taxpayer cannot hold the funds from the sale of the relinquished property themselves during the 1031 exchange transaction time frame. Typically, a qualified intermediary such as a title company or exchange company holds these funds on behalf of the taxpayer.

The time frame is very important; if certain actions aren’t completed by specified dates, the transaction will not qualify for Section 1031 and the entire capital gain will be taxable in the year of sale. The first important date is the date the replacement property has to be identified – the taxpayer has 45 days from the sale date of the relinquished property to identify the property they wish to purchase. Identification must occur in writing and be specific, i.e. include the legal description of the property. The qualified intermediary must have record of the identification, not just the taxpayer’s real estate agent or accountant. The taxpayer then has 180 days from the sale date of the relinquished property to successfully purchase the replacement property.

Here’s a quick example: A taxpayer owns a rental property. They purchased it 5 years ago for $500,000 and it has appreciated 20% meaning they can currently sell it for $600,000. Normally, the taxpayer would pay capital gains tax in the year of sale on $100,000 (the difference between the sales price and what they paid for it- ignoring improvements and depreciation for the sake of this example). The taxpayer doesn’t want to have to pay this capital gains tax right now, so purchases another rental property for $600,000 – investing all of the proceeds into another like-kind property. The capital gains tax is deferred until such time as the taxpayer sells the new rental property, unless they decide to do another 1031 exchange.