What is a 1031 Exchange in Real Estate?

A 1031 exchange entails swapping one real estate investment property for another, deferring capital gains taxes. Section 1031 of the Internal Revenue Code (IRC) is the origin of the term 1031 exchange. It is often used by real estate agents, investors, title companies, and mortgage brokers like us. What is a 1031 exchange in real estate? We have already given you a simple and straightforward answer. Now, we will take you through the details.

The IRC Section 1031 has several moving parts that real estate investors have to understand before trying to use it. An exchange can only be carried out with like-kind properties. Also, the IRS rules limit its use with vacation properties. Certain tax implications and time frames can also cause problems.

An Overview of Section 1031

Essentially, a 1031 exchange lets real estate investors trade an investment property for another of a similar type. In doing so, they can avoid recognizing capital gains during the swap. Most swaps can be taxed as sales, but if yours meets the requirements of 1031, you will either have no tax or limited tax due at the time of the exchange. This allows you to roll over your profits from one investment property to the next, thereby deferring taxes until you eventually sell the property for cash.

There are no limits on the frequency of 1031 exchanges. If everything works out as planned, you will pay only one tax at a long-term capital gains rate. In 2024, it was 15% or 20% depending on income, and 0% for some lower-income taxpayers.

For instance, you can exchange an apartment building for raw land or a commercial property. As long as the properties are used for business or investment purposes and are located within the country, they qualify for a real estate exchange 1031. While the rules are surprisingly liberal, people with limited knowledge might find themselves in situations they would rather avoid.

The provision of a 1031 exchange is for investment and business property, but the rules can apply to a former principal residence under specific conditions. You can even use 1031 to swap vacation homes. Unfortunately, this loophole has become narrower than it used to be.

Depreciable Property Rules

Exclusive rules come into play when a depreciable property is exchanged. It can trigger a profit called depreciation recapture, which is taxed as ordinary income. In most instances, you can avoid this recapture by swapping one building for another. However, if you exchange improved land with a building for unimproved land without a building, the depreciation that you have previously claimed on the building will be recaptured as ordinary income.

Changes to 1031 Rules

The Tax Cuts and Jobs Act (TCJA) was introduced in December 2017. Before its passage, some exchanges of personal property, such as aircraft, franchise licenses, and equipment, qualified for a 1031 exchange. Now, only real estate defined in Section 1031 qualifies. Know that the TCJA full expensing allowance for certain tangible personal property may help to make up for this change to tax law.

Timelines and Rules for 1031 Exchange

Originally, an exchange involves a simple swap of one property for another between two individuals. Then again, the odds of finding someone with the exact property you want who also wants your property are somewhat slim. That is the reason behind the delays in exchanges, particularly in three-party or Starker exchanges.

There are two primary rules associated with timing that must be observed in a delayed exchange.

45-Day Rule

The first timing rule in a 1031 real estate exchange is associated with the designation of a replacement property. Once your property is sold, the intermediary will receive the cash. You cannot accept this cash, or it will spoil the 1031 treatment. Additionally, within 45 days of selling your property, you have to designate the replacement property in writing to the intermediary, specifying the property you wish to acquire.

The IRS says you can designate three properties if you eventually close on one of them. If the properties fall within certain valuation tests, you can designate more than three.

180-Day Rule

The second timing rule in a delayed exchange relates to closing. You must close on the new property within 180 days of the sale of the old property.

Reverse 1031 Exchange

There is one more possibility – buying the replacement property before selling the old one and still qualifying for a 1031 exchange. In this case, the same 45 and 180-day time windows apply.

To qualify, you must transfer the new property to an exchange accommodation titleholder, identify a property for exchange within 45 days, and complete the transaction within 180 days after the replacement property was purchased.

Tax Implications of 1031 Exchange: Cash and Debt

The proceeds from a 1031 exchange have to be handled carefully. If there is any cash left over after the exchange, which is called “boot,” it will be taxable as a capital gain. Similarly, if there is a discrepancy in debt, the difference in liabilities will be treated as “boot” and taxed accordingly.

One of the main ways people get into problems with these transactions is by failing to consider loans. You must consider mortgage loans or other debt on the property you relinquish and any debt on the replacement property. If you do not receive cash back but your liability drops, then that also will be considered income to you, just like cash.

1031 Exchange for Vacation Home

Maybe you have heard of taxpayers who used the 1031 provision to swap one vacation home for another, perhaps even for a house where they hope to retire, and Section 1031 delayed any recognition of gain. Later, they moved into the new property, converted it into their principal residence, and eventually planned to take the $500,000 capital gain exclusion. This lets you sell your principal residence and, along with your spouse, shield $500,000 in capital gain as long as you have lived there for two years out of the past five.

Congress tightened this loophole in 2004. However, taxpayers can still transform vacation homes into rental properties and do a 1031 exchange for real estate. If you manage to acquire a tenant and conduct yourself in a businesslike way, then you have probably converted the house to an investment property, which should make your 1031 exchange all right.

Based on the rules of the IRS, offering the vacation property for rent without having tenants would disqualify the property for a 1031 exchange.

Moving Into a 1031 Swap Residence

If you want to use the property for which you swapped as your new second or even principal home, you cannot do that right away. In 2008, the IRS introduced a new safe harbor rule. In it, the IRS said that it would not challenge whether a replacement dwelling qualified as an investment property for purposes of Section 1031. To meet the safe harbor in each of the two 12-month periods immediately after the exchange,

• You must rent the dwelling unit to another person for a fair rental for 14 days or more.

• Your personal use of the dwelling unit cannot exceed 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

There is more: after successfully swapping one vacation or investment property for another, you cannot immediately convert the new property to your principal home and take advantage of the $500,000 exclusion.

The law changed in 2004, but before that, an investor could transfer one rental property in a 1031 exchange for another rental property, rent out the new rental property for a period, move into the property for a few years, and then sell it. This gave them the advantage of exclusion of gain from the sale of a principal residence.

If you acquire property in a 1031 exchange and later attempt to sell it as your principal residence, the exclusion will not apply during the five-year period starting with the date when the property was acquired in the 1031 like-kind exchange.

1031 Exchange for Estate Planning

One of the most significant pros of 1031 exchanges is their potential for estate planning. When you die, your heirs inherit your property as its stepped-up market value, and they will not have to pay the capital gains tax you deferred. To be precise, a 1031 exchange can pass the tax liability onto the heirs.

Reporting 1031 Exchanges to the IRS

You have to notify the IRS of the 1031 exchange by compiling and submitting Form 8824 with your tax return in the year when the exchange occurred.

In this form, you need to provide descriptions of the properties exchanged, the dates when they were identified and transferred, any relationship that you may have with the other parties with whom you exchanged properties, and the value of the like-kind properties. You also have to disclose the adjusted basis of the property given up and any liabilities that you assumed or relinquished.

You must complete the form correctly without error. If the IRS believes you have not played by the rules, you could be hit with a big tax bill and penalties.

To Conclude

What is a 1031 exchange in real estate? Savvy investors can use it as a tax-deferred strategy to build wealth. However, it has many complex moving parts. Naturally, you need to understand the rules and enlist professional help. This goes for seasoned investors, too.

FAQs

Q1. Can you do a 1031 exchange with international property?

A1. No, 1031 exchanges only apply to real estate located within the United States. Foreign properties do not qualify as like-kind assets under current IRS rules.

Q2. Is it possible to partially reinvest and still qualify for a 1031 exchange?

A2. Yes, but any portion not reinvested is considered “boot” and is subject to capital gains tax. Only the reinvested amount remains tax-deferred.

Q3. Can you use a 1031 exchange to flip houses?

A3. No, properties held for resale or short-term profits, such as flips, are not eligible. 1031 applies only to long-term investment or business-use properties.

Q4. What happens if the replacement property is of lesser value?

A4. You can still proceed, but the difference in value becomes taxable as boot. The capital gain on that difference must be reported and taxed accordingly.

Q5. Do you need a qualified intermediary for a 1031 exchange?

A5. Yes, a qualified intermediary is essential. They hold the sale proceeds and facilitate the exchange, ensuring compliance with IRS rules to maintain tax-deferred status.