1031 Exchange: Recapping the Basics
March 16, 2023
Named for Section 1031 of the Internal Revenue Code, a 1031 Exchange is a type of tax-deferred property exchange that allows real estate investors to defer capital gains taxes when selling one investment property for another. It involves using the profit from the sale of one property to acquire a like-kind piece of real estate of equal or greater value within a specific time limit.
While completing a 1031 Exchange can help taxpayers build wealth by saving on taxes normally due upon the sale of a property, IRS rules limit the use of such exchanges for business, investment or trade purposes only. For example, taxpayers may not exchange their rental unit property for a personal vacation home.
Since finding someone with the property you wish to exchange for who is willing to exchange for your property at the same time is not always quick or easy, many sellers do a delayed or third-party exchange, employing a Qualified Intermediary (QI) to manage the funds from the sale of the relinquished property and look for a replacement within the required 45 calendar days.
Once the process is complete, the investor does not have to pay the full amount of capital gains taxes they would have otherwise paid and, if the replacement property is valued higher than the relinquished property, the taxes may be delayed indefinitely.
Because, under current regulations, there is no limit on how many times an investor can perform a 1031 Exchange, provided the IRS rules are strictly followed, an investor may use the 1031 Exchange again and defer taxes on the subsequent sale. Investors are generally advised, however, to hang onto the new property for at least two years before a second exchange, lest the IRS see it as a ‘flipping’ ploy.
Another advantage of the 1031 Exchange is that when the original seller dies, any deferred capital gains taxes from the exchanges are erased. Those properties pass on to seller’s heirs without the deferred taxes, and the heirs then have several options for continuing the deferred capital gains.
In addition to deferred capital gains taxes and debt erasure upon death, the successful 1031 Exchange user enjoys increased purchasing power and improved cash flow.
But while the benefits of using the 1031 Exchange are clear, there are some drawbacks – notably that every regulation must be followed to the letter or be seen by the IRS as a failed exchange. For that reason, newer investors, especially, should consider working with an experienced specialist in such exchanges to be sure the process is correctly handled.
Bobbi Pronin is an award-winning writer based in Orange County, Calif. A former news editor with more than 30 years of experience in journalism and corporate communications, she has specialized in real estate topics for over a decade.