What Is a 1031 Exchange?
For many years, investors have used the 1031 exchange rules in the tax code to avoid paying gains when exchanging one Old Town Alexandria home or property for another. This transaction, often called a like-kind exchange, allows certain people to exchange specific kinds of property without considering gains and losses. Tax law changes in 2018 altered the options that people have when considering this type of property transfer, although it is still available under specific terms. With this information, people will be able to identify the common features and limitations of the 1031 exchange.
1. What Are 1031 Exchanges?
The Internal Revenue Service allows investors to delay when they pay taxes on the gains on property they sell. This is because investors may buy and sell properties on a regular basis. When they do, they often face tax liability on the property's gain in value. Unlike people who sell a home as a primary residence, investors generally cannot exclude most capital gains from their taxes.
A 1031 exchange describes the process that investors use to defer those gains. When people complete the exchange, they file paperwork with the IRS to document it. They will eventually need to pay taxes on it. In many cases, they can wait until they sell the property for cash, personal property, or other assets that do not qualify for a like-kind exchange.
2. How Does It Work?
Investors often use a 1031 exchange to trade up to a better property with more potential, although this is not always true. In the general case, people will prepare and post an investment property for sale. They should be open from the outset that they are intending to sell it as part of a 1031 exchange, so that it is clear how funds must be handled. Once the sale is complete, a designated party who is not the seller or their agent holds the funds for the real estate purchase.
After closing, investors have a limited time to buy. It starts with 45 days to identify properties they would like to buy as part of the exchange. Some people may already be under contract for the purchase at this time. They must close on and receive the purchased real estate within 180 days of the sale of their previous property or the date their taxes are due, whichever is first. If they fail to meet this deadline, they may have to pay taxes on the gains.
3. Are There Limitations to the 1031 Exchange?
There are many limitations to the ways that investors can use a 1031 exchange, although there are also a few exceptions. Like-kind exchanges usually involve:
- property used for investment, not for personal use or sale
- sale and purchase of real estate in the U.S.
- two properties with an adjusted basis that is close to the same
- selling and buying at nearly the same time
Some people want to do what is referred to as a deferred exchange, although this is much less common. This process involves exchanging one property for another without using purchase money as an intermediary. Most people buying real estate in a 1031 exchange will sell property for cash, have a third party hold the funds, and then use that cash to buy the second property.
4. How Did Tax Reform Change This Process?
Prior to 2018, investors had some flexibility in the types of property they could use for the exchange. People used to be able to sell certain kinds of personal property, like equipment, in exchange for real estate. This is no longer the case. Investors must exchange U.S. real estate for U.S. real estate. The like-kind exchange does not have to be exact. For example, someone who owns an apartment building that they improved can use a 1031 exchange to buy land on which they plan to build and rent apartments.
5. How Does a Like-Kind Exchange Affect Home Buying?
When investors look at properties they would like to buy in a 1031 exchange, value and liability is quite important. Besides the time limits, people may face tax liability in certain cases. For example, if the investor has some cash left over from the proceeds of the first property after buying the second, they will need to pay taxes on it. Similarly, if they do not have cash remaining but their mortgage liability is now lower, that may also be considered a gain.
People who are buying a home sold as part of a like-kind exchange may not notice much difference to the process. Investors selling a property this way may prepare it for sale quite a bit like any other home sale. The primary difference is that they will make this information known from the outset. They may also need to interact with their designated intermediary to hold the funds, like a title company.
A 1031 exchange may make it easier for investors to sell and buy real estate without increasing their tax liability, but it is not a simple process. With this information and careful planning, people can consider whether or not it is a good idea for them.