What Is a 1031 Exchange?
If you want to add investment real estate to your portfolio, you may want to know what a 1031 Exchange is. While the rules and regulations for this tactic can get complicated, understanding the basic concepts may help you decide if this strategy is right for you.
Conducting a 1031 Exchange involves a complex set of tax rules and regulations. Before moving forward, consider working with a professional familiar with the rules and regulations. Also, this article is for informational purposes only. It is not a replacement for real-life advice, so consult your tax or accounting professional before moving forward with a 1031 Exchange.
Here's what a 1031 Exchange is and some requirements to help you determine if you should pursue this avenue further.
What is a 1031 Exchange?
In the simplest terms, a 1031 Exchange is a real estate investment strategy that allows you to defer your capital gains taxes on an investment property if you sell it and buy another "like-kind" property. According to the Internal Revenue Service, "if you make a like-kind exchange, you are not required to recognize a gain or loss under Internal Revenue Code Section 1031."1
1031 Exchange Requirements
While a 1031 Exchange can be an excellent strategy for deferring capital gains taxes, there are some requirements to consider to ensure that both properties are eligible. Here are a few of the main requirements:
- The property you sell must have been an investment property, not your primary residence. The IRS defines a property as a primary residence "if it's used for personal purposes during the tax year for more than the greater of 14 days or 10 percent of the total days rented to others at a fair rental value."2
- Because a 1031 Exchange is considered a swap, you need to designate the next property shortly after selling the first property. According to the IRS, "you have 45 days from the date you sell the relinquished property to identify potential replacement properties."3
- In addition to this 45-day rule, you must close the new property within 180 days.3
- Lastly, the funds from the 1031 Exchange must be in an escrow account, and you can't receive them personally.
What Investors Might Get the Most Out of a 1031 Exchange?
As you can see, there are a lot of specifics to consider when researching 1031 Exchanges. Because of this, they aren't suitable for everyone. A 1031 Exchange may be appropriate for people looking to acquire additional real estate, especially if they already have an investment property.
Another consideration with a 1031 Exchange is that if you pass away without selling the property obtained through a 1031 Exchange, your heirs may not pay capital gains taxes. In addition, they may not inherit it at its stepped-up market rate value.4
To summarize, a 1031 Exchange may allow you to:
- Defer paying capital gains taxes on an investment property if you "swap" it for another investment property
- Use as part of an estate strategy
- Continue to generate income from an investment property while also managing tax-deferred equity in the property
1. IRS.com, November 2022
2. IRS.com, November 2022
3. IRS.com, November 2022
4. Investopedia.com, July 19, 2022