For investment-property owners looking to sell, high prices could mean commensurately high capital gains taxes. Such sellers might want to consider a so-called 1031 exchange, which could allow them to defer taxes by using the proceeds of the sale of one investment property to purchase a similar property.
What is a 1031 exchange?
Under IRC Section 1031, business owners, individuals, and trusts may perform a tax-deferred exchange of one business or investment property for another. Be aware that only real property, including buildings, land, or other real estate, is eligible for a 1031 exchange. Generally, personal property such as machinery and vehicles, intellectual property like copyrights and patents, securities, and financial instruments such as inventory and partnership interests are excluded.
1031 exchange rules
The IRS has very specific rules regarding 1031 exchanges. Here are a few to keep in mind:
The seller must buy like-kind property. The buildings, land, or other real estate must be "like-kind" in nature—meaning the properties being sold and purchased must both be a real estate investment or part of a business. Property for personal use, such as a primary residence or vacation home, doesn't qualify.
The seller must make a like-kind exchange. To receive a 100% tax deferral, the property or properties acquired must be equal to or of greater value than the property being sold. If the purchase price of the new property is lower, the seller may be subject to depreciation recapture on any gains—up to a 25% ordinary income tax.
The seller must meet certain time limits. From the date of the sale, the seller has 45 days to identify a potential replacement property or properties and 180 days in total to complete the purchase to minimize tax liabilities.
The seller cannot, even temporarily, take possession of the exchange funds. Proceeds from the sale of the relinquished property must be held by a qualified intermediary (QI)—an independent facilitator or entity with no financial or personal connection to the seller. The QI will hold the funds in a qualified escrow account until the purchase of the replacement property is complete.
1031 exchange tips
Taxpayers run afoul of 1031 requirements all the time. Even one tiny error could nullify the exchange, and you may be left owing taxes, late penalties, interest, and possibly even a 20% negligence penalty.
To avoid a mishap with a 1031 exchange, we recommend that real estate investors:
Document everything: To claim something as a rental property, you need proof that you rented it, including contracts and payments.
Open a dedicated bank account: A separate account makes it easier to prove rental income and property-related expenses.
Create a separate entity: To keep personal and investment properties separate, consider establishing a business entity, like an LLC, for your rental. This has the added benefit of offering potential legal liability protections.
Consult an expert: It's wise to find a CPA or an attorney who specializes in 1031 exchanges. There are specific experts who know all the legal ins and outs, as well as what paperwork to file and when, and some may even be able to help you find your next property.
Bottom line on 1031 exchanges
A 1031 exchange is sort of like having a tax-deferred investment account, but for real estate. There's no limit to how many exchange transactions you can do, so you can roll over any gains again and again—and you'll owe taxes only when you decide to keep, rather than reinvest, the funds. However, the exchange process can be complicated, so consider speaking to a financial advisor and tax professional to avoid any surprises on your tax return.
