What Is A 1031 Exchange?

Posted on Tuesday, November 01, 2022

A “1031 exchange” is the nickname used to discuss Section 1031 of the U.S. Internal Revenue Service’s tax code. This section states that if an individual exchanges one investment property for another via a 1031 exchange, they may be able to defer capital gains (or losses) they would otherwise have to pay at time of sale.

Section 1031 applies to some “property” beyond real estate, but this article focuses on the general rules for investment real estate only.

WHAT ARE THE ADVANTAGES OF A 1031 EXCHANGE AND WHEN IS IT BENEFICIAL?

The best time to do a 1031 exchange is when you are in a high tax bracket that would require you to pay a high percentage of federal income taxes, but you want to keep cash on hand for additional reinvestment to expand your real estate portfolio. By deferring the federal income taxes on trades of investment properties, more funds will be available for things such as, acquiring additional or more valuable investment property, decreasing debt by making a larger down payment or increasing available cash needed for improvements, etc.

There is no limit on the number of §1031 exchanges you can do, so you can keep investing and swapping properties for as long as you like, and then only pay taxes once when you sell your properties for cash. It is also important to consider the attractive nature of §1031 exchanges for estate planning.

USING 1031 EXCHANGES FOR ESTATE PLANNING

1031 exchanges benefit the real estate investor through the benefit of deferring taxable gains until the property is sold. If the investor sells the property for cash prior to death, tax would be due on the capital gains resulting from the sale of the property. However, rather than selling property prior to death, tax can be avoided by allowing it to pass to heirs after death. Once the properties are inherited, heirs receive a full step-up in basis based on the fair market value of the property at the time the property is passed on. As a result, the heirs could immediately sell the property with little or no tax consequence. Alternatively, if the heirs keep the property rather than selling, they can depreciate it as if they had purchased the property that same day. This is an extremely powerful and advantageous tool for real estate investors – especially if they have performed multiple exchanges and traded up into larger, quality assets.

WHEN IS A 1031 EXCHANGE NOT ADVANTAGEOUS?

If you are in a low tax bracket one year, you may want to hold off on a §1031 exchange and just pay the taxes that year at a lower rate than you would later if you know you’re going to be making more money in the future.

Additionally, if you have a loss on the year, there would be no gain on which to pay taxes, so it would not make sense to do a §1031 exchange in that instance either. Capital losses are limited to $3,000 per year for single individuals. Or, if you are in a low enough income tax bracket that you fall into the 0% capital gains tax bracket, you also would not owe tax on the sale, therefore, the 1031 exchange would serve no purpose.

WHAT PROPERTY QUALIFIES?

What types of properties quality for a 1031 exchange? The short answer: it depends. This is because the language used in the tax code is vague. Properties must be, it says, “like-kind.”  Per the IRS: “Both properties must be similar enough to qualify as ‘like-kind.’ Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements conveyed without land are not of like kind to land.”

RESTRICTIONS ON 1031 EXCHANGES

Investors must consider additional restrictions, beyond the definition of “like-kind.” A tax professional will illustrate each one, but a few major considerations include:

You must own the real estate. Owning a share in a REIT, a fund or an LLC that owns a share in another LLC does not qualify.

You can only perform a 1031 exchange for real property. Personal property, such as equipment does not qualify.

If you exchange for a cheaper property, a current income tax liability for a portion of the gain will likely result. Additionally, cash payments or property considered not-like-kind exchanged as part of the transaction may be considered “boot” and subject to tax currently.

The exchange may be deferred, allowing time between transactions to identify and replace the like-kind property. In this case, a qualified intermediary must be used to sell the property and hold the proceeds until like-kind property is purchased. This step is important, because if the taxpayer is deemed to have actual or constructive receipt of the proceeds, the exchange would be invalid, resulting in a non-deferred taxable sale.

Additionally, there are important timing restrictions applicable to delayed exchanges.

Per the IRS:

“The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient."

There’s a second deadline, too. The “property must be received, and the exchange completed no later than 180 days after the sale of the first exchanged property.”

As you can see, 1031 exchanges can provide various income tax benefits, but their execution is tricky as there are many potential pitfalls, even for seasoned investors. There are so many caveats with the potential to ensnare investors. If the whole transaction isn’t executed exactly right, you may end up paying taxes on the entire sale. Additionally, income tax laws can change. Currently there’s a proposal to cap the amount of gains that can be deferred. Therefore, it is essential to secure professional help prior to considering a 1031 exchange.

Posted in Tax Topics For Individuals

Disclaimer: The information contained in Dulin, Ward & DeWald’s blog is provided for general educational purposes only and should not be construed as financial or legal advice on any subject matter. Before taking any action based on this information, we strongly encourage you to consult competent legal, accounting or other professional advice about your specific situation. Questions on blog posts may be submitted to your DWD representative.