How does a 1031 Exchange work?

[Bryan C.]

Can someone please explain how a 1031 Exchange works?

[Bill Exeter]

Hi Chris,

$225K is your net sale price, so that is the amount that you must reinvest, not just your equity of $100K.  You must acquire one or more replacement properties that have a total purchase cost of at least $225K, and you must reinvest all of your cash, if you want to defer all of your taxes.  If you trade down in value (e.g., buy replacement property for less than $225K) or you pull cash out, it will trigger taxable boot. In your case, if you have a gain of $50K, and you either trade down by $50K or more or you pull cash out of $50K or more, the 1031 Exchange will not provide any benefit and you will recognize all of you taxable gain.

Hi Richard,

1031 Exchange transactions only apply to property held for rental, investment or business use.  They do not apply to primary residences, second homes or vacation homes.  Primary residences fall under Section 121 of the tax code, which is the $500,000 tax free exclusion that you mentioned. 

However, in your example, if this was your primary residence and you had a $1.0 million gain, you could move out of the property, rent the property for about 24 months, and then sell.  In this case, you could still  say that you had owned and lived in the property for 24 months out of the last 60 months (2 out of the last 5 years) and would qualify for the 121 Exclusion, and because it was rented for the most recent 24 months and was rented at the time of sale, you would also qualify for a 1031 Exchange because you had rented it out for a period of time.   So, combining the two strategies is possible with proper planning.  In this case, you would get the $500,000 tax free (assuming that you are a married couple), and then you would have to reinvest the remaining $1.0 million.  Remember that you must reinvest the net sale price and not the profit or the equity.