If you plan to part with a piece of investment real estate, you might be able to postpone paying capital gains taxes by using a type of transaction called a 1031 exchange. But beware: Strict rules apply to these 1031 exchange real estate deals.
Bottom Line Personal asked tax expert Abby Eisenkraft what owners of investment real estate need to know about 1031 exchanges…
What Is a 1031 Exchange?
Also known as a like-kind exchange, a 1031 exchange involves swapping one piece of investment real estate for another in a way that doesn’t generate capital gains tax at the time of the trade.
The type of investment real estate obtained does not have to be the same as the type traded away—a piece of undeveloped land could be exchanged for a single-family home to be rented out, for example. The swapped properties don’t need to be in the same area, either, though both do need to be in the US…if they are foreign properties, both must be outside the US. And crucially, property owners do not need to find other property owners who want to trade properties with them to take advantage—a 1031 exchange can involve selling a piece of property to one person and buying a piece of property from another. Prior to 2018, 1031 exchanges could be used to swap certain non-real estate property as well, but that’s no longer allowed.
Six Key 1031 Exchange Rules
For a 1031 exchange to pass IRS muster…
- Both properties must be investment or business real estate. You cannot do a 1031 exchange with a personal residence. But a variety of investment properties do qualify, including commercial buildings, apartment buildings, single-family homes that are rented out, farmland, undeveloped land and more. Important: A vacation home you own could potentially qualify for a 1031 exchange, but only if it has been rented out and treated as an investment property during the most recent two years with extremely limited or no personal use.
- A strict 1031 exchange timeline must be followed. A pair of ticking clocks can cause problems for people who attempt 1031 exchanges. Once your original property is sold, you’ll have just 45 days to identify the property that you intend to obtain…and just 180 days from the initial sale date to close on this new property. It’s not uncommon for 1031 exchanges to fail because the purchase of a replacement property falls through or gets delayed.
- You can’t touch the money. The money you’re paid by the buyer of your original property must remain in the hands of a qualified intermediary until it’s used to purchase the new property. If you take possession of this money, the transaction will become ineligible for a 1031 exchange. Your tax advisor, real estate attorney and/or real estate agent might be able to recommend an appropriate qualified intermediary.
- Some tax might be due if the dollars don’t match. If the property you acquire in a 1031 exchange costs less than the amount that you received for your prior property…or if the prior property has a larger outstanding mortgage debt than the new one…then the difference likely will be subject to capital gains taxes. If you receive cash to make up the difference, the cash is treated as “boot” and is taxable to the extent of the gain.
- You’ll need to report the transaction to the IRS. This can be done by filing Form 8824, Like-Kind Exchanges, with your tax return.
- Capital gains taxes are delayed, but they don’t disappear entirely. A 1031 exchange can kick the capital gains tax bill down the road, but that tax bill will come due when you later sell the property you obtained through the 1031 exchange. Potential exceptions: Rather than sell the property you obtain in a 1031 exchange, you could later use that property in another 1031 exchange, kicking the can even farther down the road. And if you never sell a property obtained through a 1031 exchange and instead leave it to your heirs in your estate, those heirs likely will qualify for a step up in basis, which means they won’t have to pay capital gains taxes on the increase in value that occurred during your lifetime. But: Leaving investment real estate to heirs can create complications for them—it’s a topic worth discussing with your estate-planning attorney.
