The 1031 tax-deferred exchange is a method of temporarily avoiding capital gains tax on the sale of an investment or business property. This property exchange takes its name from Section 1031 of the Internal Revenue Code (IRC). It allows you to replace one investment or business property with a like-kind property and defer the capital gains on the sale if Internal Revenue Service (IRS) rules are meticulously followed.
In theory, an investor could continue deferring capital gains on investment properties until their death, potentially avoiding paying taxes on them. It's a wise tax and investment strategy as well as an estate-planning tool. These taxes can run as high as 15% to 30% when state and federal taxes are combined. The 1031 exchange has been a major component of the success strategy of countless financial wizards and real estate gurus.
Key Takeaways
- Congress changed and clarified some of the rules for 1031 exchanges in the Tax Reform Act of 1984.
- Only certain types of properties are eligible, and a personal residence isn't one of them.
- The potential replacement property must be identified within 45 days, including weekends and holidays.
- You generally have 180 days from the date the relinquished property is transferred to the buyer to close on the replacement property, but there's one exception.
The Law Changed in 1984
Congress passed changes to Section 1031 in the Tax Reform Act of 1984 after a series of liberal court decisions gave real estate investors wide latitude in the types of properties that could be exchanged and the time frames in which they could complete the exchanges. This legislation further defined "like-kind" property and established a timetable for completing the exchange.
Qualifying Properties
Only real property that's held for business use or as an investment qualifies for a 1031 exchange. A personal residence doesn't qualify and a fix-and-flip property generally doesn't qualify because it fits into the prohibited category of a property purchased solely for resale. Vacation or second homes that aren't held as rental properties usually don't qualify for 1031 treatment, but there's a usage test under Section 280A of the tax code that may apply to those properties.
Note
You should consider consulting a tax expert to see whether your second or vacation home qualifies under Section 280A. It may be if it's used as your principal place of business or is rented out, in whole or in part.
Land that's under development for resale doesn't qualify for tax-deferred treatment. Stocks, bonds, notes, and beneficial interests in a partnership aren't considered to be a form of "like-kind" property for exchange purposes.
The transaction must take the form of an "exchange" rather than just the sale of one property with the subsequent purchase of another. First, the property being sold and the new replacement property must both be held for investment purposes or for productive use in a trade or a business. They must be "like-kind" properties.
The following real estate swaps are examples of those that fit the requirement for a qualified exchange of "like-kind" property:
- An office in exchange for a shopping center
- A shopping center in exchange for raw land
- Raw land in exchange for an industrial building
- An apartment building in exchange for an industrial building
- A ranch or farm in exchange for an office building
Purchase Deadlines
Prior to 1984, virtually all exchanges were done simultaneously with the closing and transfer of the sold or relinquished property and the purchase of the new real estate or replacement property. In addition to the problems encountered when trying to find a suitable property, there were difficulties with the simultaneous transfer of titles as well as funds. The delayed 1031 exchange avoids these pre-1984 problems, but stricter deadlines are imposed.
An investor who wants to complete an exchange lists their property in the usual way. When a buyer steps forward and thepurchase contractis executed, the seller enters into an exchange agreement with a qualified intermediary who becomes the substitute seller. The exchange agreement usually calls for an assignment of the seller’s contract to the intermediary. The closing takes place and the intermediary receives the proceedsbecause the seller can't touch the money.
Identifying Properties
The first timing restriction, a 45-day rule for identification, begins at this point. The investor must either close on or identify in writing a potential replacement property within 45 days from the closing and transfer of the original property. The time period isn't negotiable and it includes weekends and holidays. The entire exchange can be disqualified and taxes are sure to follow if the investor exceeds the time limit.
The investor can either identify three properties without regard to theirfair market value or a larger number of properties as long as their aggregate fair market value at the end of the identification period does not exceed 200% of the aggregate fair market value of the relinquished property as of the transfer date.
Note
The exchange won't fail if the three-property rule and the 200% rule are exceeded, but the taxpayer purchases identified replacement properties whose fair market value is 95% or more of the aggregate fair market value of all identified replacement properties.
Avoiding "Boot"
Realistically, most investors follow the three-property rule so they can complete due diligence and select the property that works best for them and that will close. The goal is generally to trade up to avoid the transfer of "boot" and to keep the exchange tax free.
"Boot" is money from (or the fair market value of) any non-like-kind property that's received by the taxpayer through the exchange.Boot could be cash, a reduction in debt, or the use of sale proceeds for costs at closing that aren't considered to be valid closing expenses. The rules governing boot in an exchange are complex, and an investor could inadvertently receive boot and end up owing taxes without expert advice.
Buying the Replacement Property
When a replacement property is selected, the taxpayer has 180 days from the date the relinquished property was transferred to the buyer to close on the new replacement property. But the exchange must be completed by the earlier date if the due date for the investor'stax return for the tax yearin which the relinquished property was sold is earlier than the 180-day period end date.
Note
Because there are no extensions or exceptions to this rule, it is advisable to schedule the closing for the replacement property prior to the deadline.
The law requires that the investor not touch the proceeds from the first transaction so thequalified intermediaryacquires thereplacement propertyfrom the seller at closingand transfers it to the investor after the transaction is completed.
Frequently Asked Questions (FAQs)
What is a reverse 1031 tax-deferred exchange?
A reverse 1031 tax-deferred exchange is essentially the same transaction as a 1031 exchange but it's a "reverse" tax-deferred exchange. The second investment property is purchased before the sale of the first property.
What is taxable in a tax-deferred exchange?
The 1031 tax-deferred strategy only defers taxes. It doesn't help you dodge them entirely. Everything that would normally be taxable is still taxable under a tax-deferred exchange. The only difference is that the taxes won't be paid in the year of the sale.
