IRS 1031 Exchanges: How to Save Money on Your Real Estate Investments

1031 Exchange Real Estate

The IRS 1031 exchange, which allows you to delay the payment of any capital gains tax owed on the sale of investment property, is an extremely valuable tool for successful real estate investors.

December 20, 2015

If you make a gain from a sale, you generally have to pay a tax on the gain. If you don’t know this already, you will soon enough. But there is an exception for the savvy called the like-kind exchange, also known as a 1031 exchange.

Simply put, it allows you to defer the tax on the gain of a sale if you reinvest it in something similar. This exception is broad, and applies to both personal property and real property.

However, the most notable exception is this: both properties, whatever they may be, must be held for use in either a business, trade, or as an investment. Therefore, if you decide you no longer like your vacation home and want the one down the street instead, this sale would not qualify as a 1031 exchange since the principal use is one of a personal nature.

But if your business is expanding and you need to sell and reinvest in a larger office, building, or whatever it may be, such a sale would qualify.

The IRS has categorized certain property as explicitly excluded, which include: inventory or stock in trade, stocks, bonds, or notes, other securities or debt, partnership interests, and certificates of trust.

What is “Like-kind”?

As the name implies (like-kind), the property being exchanged must be similar. Therefore, although you could exchange an older business truck for a newer one, you cannot exchange your truck for an office building. That being said, the restrictions on personal property are stricter than those on real property.

For example, cars are not considered like-kind to trucks, although they are both automobiles. But a vacant lot of land is considered like-kind to a lot with a home on it.

Another notable factor is that quality or grade does not matter at all. The property must only be of a similar nature, class, or character. So a beat up Honda sedan from the 80s with 200,000 miles on it will qualify as a like-kind exchange for the newest version of a different sedan (of course, if it is still for business purposes).

What are the Limits?

Currently, there are no limits on how many times you can conduct a like-kind exchange on certain property. You can keep rolling over the gain from one piece of investment property into the next, allowing the property to grow tax deferred. When, and if, you ultimately decide to sell, you will only pay the tax on that one ultimate sale. That’s the beauty of the 1031 exchange.

Real Estate Specifics

1031 exchanges are predominantly popular, and mostly used, in regards to real estate. As stated earlier, the restrictions are more lenient and broader on real property, so it makes it easier. Similarly, exchanges for business or investment often concern real property, so this exception inherently has more utility in the real estate arena. But there are some requirements that must be adhered to when exchanging real estate.

First, the taxpayer must be the same for both transactions (the selling and buying).

Secondly, the taxpayer has 45 days to identify the potential replacement property, to which certain restrictions apply as well.

Thirdly, the replacement property must be purchased within 180 days of closing of the first property.

Fourthly, in order to defer 100% of the tax, the net market value and equity of the property being sold must be equal to or greater in the replacement property.  If it is not, the taxpayer will pay tax on the difference.

Fifthly, one must be wary of conducting an exchange with a related party since there is a strict holding requirement that must be adhered to.

A related party is generally a member of the immediate family and corporations, LLCs, or partnerships where more than 50% of the stock or interest is held by the taxpayer. In order for a related party transaction to be a valid 1031 exchange, the properties must be held for at least two years before being sold, otherwise the tax deferred will be due. The purpose of this rule is to essentially ascertain that the exchange is for business or investment purposes by making both parties hold the property for a longer period. The related party requirement attempts to curb investor abuse by those who try to avoid or evade their tax liabilities using this tool.

How Can I Conduct a 1031 Exchange?

This article is by no means an exhaustive tutorial on the complexity of the 1031 exchange. There are countless factors to consider and analyze when considering such a transaction, such as depreciation recapture, capital gains tax recognition, your cost basis in the property, and many more. This article has simply skimmed the surface and introduced you to the beloved 1031 exchange. In order to take part in one, much more research and professional assistance is highly recommended. 

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