If you invest in real estate, you will want to know all about a 1031 exchange. Named for IRS Section 1031 of the tax code, a 1031 exchange can be a useful tax strategy for deferring capital gains tax on business and investment properties and for building long-term wealth. A 1031 exchange comes with a lot of rules and regulations, so keep reading to learn what you need to know about this handy tax strategy. 

What Is a 1031 Exchange?

In simple terms, a 1031 exchange is a legitimate tax strategy that allows real estate investors to swap one investment property for another without paying a capital gains tax at the time of sale. A 1031 exchange is particularly useful if you are looking to upgrade your investment property holdings without being charged tax for the transaction. There are three keys to a successful 1031 exchange:

• The money exchanged for the swapped investment properties must never touch your hands. Instead, it must be held in escrow by a third party until the real estate transaction is complete. 
• There are two very specific, simultaneous timelines that must be adhered to during the 1031 exchange: the first for identifying a replacement property in writing, and the second for acquiring a new property. 
• The rules and regulations for conducting a 1031 exchange are complex; we recommend working with a 1031 exchange expert to make sure everything is carried out correctly. 

What Are the Rules for a 1031 Exchange? 

The IRS sets forth a number of rules and guidelines for real estate investors seeking to conduct a 1031 exchange. 

First, the exchange can only be carried out with like-kind properties.

Like-kind properties, according to the IRS, are two real estate assets of a similar nature, irrespective of grade or quality. A like-kind property is one that is held for business, trade, or investment purposes. As such, personal residences do not qualify as like-kind properties. Here are a few examples of like-kind properties for the purposes of a 1031 exchange:

• A condominium for a hotel 
• Vacant land for a retail property
• An apartment building for an industrial building
• A shopping complex for a medical property
• A parking lot for a vacant school building 

As you can see from the above examples, the like-kind definition places less emphasis on the similarities between the properties and more on the nature of their purpose for the owner: namely, investment and business. 

Second, the exchange must adhere to two stringent timelines.

The 45-Day Rule relates to the designation of a replacement property. It states that within 45 days of the sale of your property, you must identify in writing a replacement property for the exchange. The IRS notes that you may designate three properties (and more if specific guidelines are met), as long as you ultimately close on one of them. That brings us to the second timeline you must follow: the 180-Day Rule for closing. Simply put, you must close on the replacement property within 180 days of the sale of the old property to qualify for a 1031 exchange. 

Third, a 1031 exchange must be carried out using a qualified intermediary.

Also known as an exchange facilitator, a qualified intermediary is a third party which holds your money in escrow throughout the entire transaction process. Having a qualified third party conduct the 1031 exchange is critical; if money enters your hands at any time during the transaction, you nullify the purchase as 1031 eligible and will be taxed accordingly. The job of the exchange facilitator is to sell the old property on your behalf, purchase the replacement property, and facilitate the exchange of funds. It is important to choose the right qualified intermediary—he or she cannot be a relative, your attorney, banker, employee, accountant, or real estate agent. You must choose a completely independent third party. 

Frequently Asked Questions About a 1031 Exchange

Now that you know what a 1031 exchange is and what rules apply, consider the following frequently asked questions about a 1031 exchange:

When would I consider using a 1031 exchange? 

A 1031 exchange may be the right opportunity in a variety of situations. For example, you may want to invest in a property with better return prospects than your current investment property, consolidate several properties into one for estate planning purposes, or turn your unused vacation home into a rental property then swap it for an investment property. In any of these scenarios, you could use a 1031 exchange. 

What steps are involved in conducting a 1031 exchange? 

To do a 1031 exchange, you will follow a few steps:

• Step 1 – Identify the property you want to sell.
• Step 2 – Identify the property you want to buy. 
• Step 3 – Choose a qualified intermediary.
• Step 4 – Decide how much of the proceeds you will invest in the new property. 
• Step 5 – Stay within the 45-Day Rule and 180-Day Rule deadlines.
• Step 6 – Report the 1031 exchange to the IRS on your tax return using Form 8824.

What happens to the capital gains tax in a 1031 exchange? 

When you do a 1031 exchange, the capital gains tax is deferred, meaning you won’t owe it during the tax year when you completed the exchange, but you will owe it when you go to sell the investment property, unless you continue to “1031” your current property for a new one, in which case you can defer the capital gains tax indefinitely. 

How can I use a 1031 exchange as a tax strategy for building wealth?

Using the 1031 exchange to continually defer capital gains tax on new investment properties can be an effective tax strategy. The tax-deferred funds can be reinvested into more profitable properties. Eventually, if you die without having sold property obtained through a 1031 exchange, the deferred tax debt is cancelled, and your heirs will inherit the property at the true market value. 

Who can help me with my 1031 exchange? 

Conducting a 1031 exchange is a rather complicated process. We always recommend working with a tax professional to ensure the transaction is completed correctly. If you’re looking for financial guidance for a 1031 exchange, reach out to our team of experts. 

Honest Buck Accounting exists to help Early Childhood Education businesses build a strong financial foundation. The experts at Honest Buck offer a variety of accounting services to help you streamline and optimize your financial processes and increase profitability. Contact us today.