Understanding How The 1031 Exchange Works

Tax savings are a major advantage of real estate investing, and the 1031 Exchange can save you thousands. According to the IRS, you can postpone paying capital gains tax when you sell a property and reinvest the profits in a like-kind property of equal or greater value. Selling and buying a replacement property “must be mutually dependent parts of an integrated transaction,” so hire an attorney to structure the deal properly and tell you about any recent changes to the law.

These are some Frequently Asked Questions about the 1031 real estate exchange.

Answer: The 1031 Exchange applies to like-kind property, so the original property and the replacement property have to be of the same nature. Most 1031 exchanges are for real estate investments, and you can exchange just about any type of real estate asset. For example, you can exchange a rental property for a commercial office building, or a duplex for an apartment building. Both properties must be located in the United States. Keep in mind that the 1031 Exchange is not intended for personal use, so you are not allowed to exchange your primary residence for more expensive home.

Answer: Under the 1031 Exchange, the net market value and equity of the newly purchased property must be the same or more than the property you just sold in order to defer 100% of the tax on the profits. To receive the full benefit, you are also required to carry over the same or greater mortgage amount. If you choose to purchase a property of lesser value, you have to pay capital gains on the difference in value. You can count home inspections, broker fees and other acquisition fees in the cost of your new property.

Answer: Most 1031 exchanges are delayed or Starker Exchanges, and they have very strict timing requirements. The first rule is a 45-day identification window of the new replacement property from the time you close on the sale of the first property. A qualified intermediary must hold the cash when you sell, and you are required to put your replacement choice in writing. The second timing rule for a 1031 Exchange is the 180-day purchase window. That means that you have to close on the sale of the new property within 180 days of the sale of the first property, or the date your income tax return is due for the tax year when the property was sold.

Answer: You are not allowed to use the 1031 Exchange if the name on the tax return and the name on the title don’t match. The exception to this rule is when your name appears on an LLC and you are the only LLC member.

Tips for Using the 1031 Exchange

To defer 100% of taxes on the sale of an investment property, the new property has to be of equal or greater value and all the profits have to be reinvested. If you choose to complete a 1031 Exchange and take out some of the cash, you will be taxed for that portion at the ordinary income rate. Under the 1031 Exchange, you cannot purchase the new property from a relative.