A 1031 exchange is one of many real estate investing secrets wealthy people use to save money. Learning what a 1031 exchange is can allow you to defer taxes on the gains each time you trade investment properties, which allows you to reinvest more of the proceeds each time you trade. But, if you don’t follow the 1031 exchange requirements, you can end up blowing your entire exchange and wind up with a bigger tax bill. Read on to get information on a 1031 exchange explained.
Like-Kind Property Required for 1031 Exchange
A 1031 exchange is also referred to as a like-kind exchange because the replacement property must be of a like kind as the one you relinquish. The IRS considers real property to qualify as long as it’s located in the U.S. and has the same nature or character, which generally means that it’s used as a business or investment property. This applies even if one property is improved and one isn’t, such as a construction exchange. Foreign real property isn’t considered like kind.
You also have to treat paying off a mortgage the same way as you would treat cash. However, you can use the proceeds from the sale of the relinquished property to repay the mortgage as part of the exchange if you replace that mortgage with a new mortgate or with cash when you purchase the like-kind property.
As of January 1, 2018, 1031 exchanges only apply to trades of real property that you hold for investment or business use. Previously, you could include other assets used in business, such as machinery or equipment.
Using a Qualified Intermediary
If you aren’t exchanging your old property for the new property immediately, the 1031 rules require using a qualified intermediary, such as a bank, to hold the properties or proceeds until you have completed the transfer. For example, say you are selling your rental property today but won’t close on a replacement property for two months. If you accept the cash in your bank account from the first sale, the purchase of the replacement property won’t qualify as a 1031 exchange.
The qualified intermediary must be legally obligated in a written agreement to acquire the initial property and transfer it to the person buying it from you, and to acquire the replacement property and transfer it to you.
Identifying Replacement Properties
If you sell your property prior to acquiring a new property, you need to observe the time limits for identifying your replacement property. Within 45 days, you must have identified a specific property or properties. You can identify up to three replacement properties regardless of the fair market value of them or any number of properties whose fair market value doesn’t exceed twice the fair market value of the properties you are selling.
Closing Your Exchanges
If you are selling your old property first, you must complete your 1031 exchange within the shorter of 180 days after you transfer your old property or the deadline, including extensions, for filing your tax return for the year that you transfer the old property. If you purchase your replacement property first with a reverse exchange, you must sell your old property not more than 180 days after the acquisition to qualify for the like-kind exchange.
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Daria Uhlig contributed to the reporting for this article.
Last updated: Feb. 18, 2021