What Is A 1031 Exchange?
The 1031 exchange, also known as a like-kind exchange under IRC Section 1031, allows an investor to defer the capital gain on the sale of investment property if reinvested in similar or related property. It was created with the intention that investors would diversify their investments without incurring taxes. To qualify for this tax break, certain requirements must be met, including time limitations and identification of replacement properties before selling original investment property.
How Does It Work?
A taxpayer can postpone paying capital gains taxes until they sell their new asset by using what’s called a “like-kind” rule. If you purchase another piece of real estate within 180 days of the original sale, you’re home-free. The IRS says that any building purchase must be “substantially similar” to the one sold for it to qualify as a 1031 transaction.
What Are My Time Limits?
You have 45 days from the sale or exchange of your investment property to identify potential replacement properties. Once you’ve made your selection, you have an additional 180 days to complete the purchase.
What Are Some Restrictions?
Under 1031 exchange explained, you cannot use it to avoid taxes on the sale of your principal residence, although investment properties and vacation homes can qualify. In addition, the property being sold and the replacement property must both be held for investment or business purposes.
What Are Your Tax Liabilities?
Any gain left on the table, which you haven’t deferred through a 1031 exchange, will be taxed at capital gains rates ranging from 0% to 20%, with most investors paying closer to 15%.
Are There Any Exceptions?
You cannot exchange a property you’ve used as a personal residence in the last two years.
Can I Use 1031 Exchanges on Multiple Properties?
Yes, you can use 1031 exchanges on multiple properties as long as each sale or purchase is for investment or business purposes.
How Does This Compare to a Regular Investment?
The standard investment return is taxed at your income tax rate since capital gains taxes are deferred until the property is sold.
Do I Have to Use 1031 Exchanges, or Can I Sell and Put All My Money Back In?
You can stop using like-kind exchanges as soon as you reach the point where the tax benefits outweigh the cost of the exchanges.
How Do I Find a Replacement Property?
You can seek the help of a professional real estate agent, although you are allowed to purchase properties on your own as long as you identify them within the established time limits.
What If My Investment Property Is Being Foreclosed or Going Through Bankruptcy?
In this case, the 1031 exchange would not apply, and you would be subject to capital gains taxes on the original sale. If you are selling to relocate or avoid foreclosure, these reasons may qualify for an exception.
Can I Trade Up When Using 1031 Exchanges?
Yes, but only if the property is considered like-kind. For example, you cannot upgrade from a two-bedroom apartment in the city to a five-bedroom home in suburbia.
How Do I Document My 1031 Exchange?
You can use IRS Form 8824 for this purpose.
What If the Replacement Property Is More Expensive Than the Original Property?
You must pay capital gains on the difference between your loss and the increased cost of the new investment; however, you also have to foot any additional costs.
Can I Use the 1031-Exchange Option to Avoid Paying Taxes on a Home Sale?
No. Any time you sell your primary residence, it is not considered a capital gain and cannot be deferred with a 1031 exchange. Your house may have increased in value since you bought it, but if you’ve lived there for at least two of the past five years, you can exclude up to $250,000 in capital gains from your taxable income. If you are married and file jointly, you can exclude up to $500,000.
What If I Break the Rules?
You may face penalties and interest charges on any gains you defer. The IRS considers these exchanges “tax avoidance transactions” that don’t qualify under the law, so they will come after you unless you can prove your deals are legitimate.
If you use a 1031 like-kind exchange to defer capital gains taxes on the sale of your investment properties, you will need to find replacement properties within six months.
1031 Exchange rules are tedious and incredibly important for investors to understand fully. Please consult your tax advisor or attorney before making any final decisions about 1031 exchanges.