A common term used in conversation between investors, realtors, and title companies, 1031 exchanges come with lots of moving parts. They are not the easiest part of the tax code to understand but do offer plenty of benefits. Here’s a breakdown of what 1031 exchanges are and how they work.
What is a 1031 Exchange?
Also known as a like-kind exchange, a 1031 exchange allows you to swap one investment property for another. This term actually refers to Section 1031 of the IRS code.
While most swaps will be taxable as sales, if you meet the 1031 requirements, you will pay less in taxes or no taxes with a 1031 exchange. Basically, you will have the ability to move your current investment from one property to another without the sale being recognized as a capital gain.
You can grow your investment tax-deferred with no limit on how many times or how frequently you can use 1031 exchanges. This tax code makes it possible to roll over your gain from one investment property to another and another.
Even if you have a profit on the swap, you won’t have to pay taxes until you sell for cash in the future. This allows you to pay just one tax while growing your investment over time.
While 1031 exchanges apply to business and investment property, there are some conditions where it can apply to a primary residence.
How 1031 Exchanges Work
You can use a 1031 exchange to swap investment properties, as long as you follow the rules. There are seven basic rules you need to follow to use this tax code to your benefit.
If you want to qualify for a 1031 exchange, it all starts with the like-kind property rule. This rule states that the new property you acquire must be “like-kind.” It’s a very broad term and you can swap many types of property. However, you can’t exchange something that isn’t real estate, such as farming equipment, for real estate like a duplex. You must swap a real estate property for a real estate property, such as an apartment building for a duplex or a rental property for a commercial office building.
Investment or Business Property Only
In order to use a 1031 exchange, you will need to swap investment or business property only. There are a few minor exceptions to this rule.
Greater or Equal Value
If you want to avoid paying taxes completely, you will need to follow the greater or equal value rule. This rule requires the net market value and equity of the new property to be the same or greater than the property you sell. If not, you won’t be able to defer 100% of the tax.
Must Not Receive “Boot”
Boot is the term used for the difference when you choose a new property of lesser value. If you receive boot, you will need to pay taxes on it.
Along with these rules, a 1031 exchange requires the same name appearing on the title of the property being sold to be the same as the name on the new property. You also have 45 calendar days from closing on the first property to identify up to three like-kind property. A 180-day purchase window is also necessary to use a 1031 exchange.
So, if you want to use a 1031 exchange, you will need to make sure you find a new like-kind property within 45 days of closing on the property you’re selling. Then, you must purchase this property within 180 days and it needs to be of the same value or greater value than the property you sold if you want to defer 100% of the taxes.
As long as you meet the rules of a 1031 exchange, you can gain the benefits of this part of the tax code.