Section 1031 of the US tax code allows you to do something beneficial and quite interesting: exchange real estate tax-free. Specifically, a 1031 Exchange allows you to sell a property, buy another one that better suits your financial situation, and in the process avoid capital gains taxes and recapturing depreciation.
Sounds great, right? The catch is that you must follow the rules and procedures EXACTLY, otherwise, the transaction will not qualify as a 1031 Exchange, and you’ll be stuck with a high capital gains tax bill on the sold property, given the rise in market value and relatively low cost basis (since all the depreciation will then be “recaptured” or subtracted from the original purchase price).
Here are 6 things you need to know for a successful exchange:
- Your primary residence does NOT qualify for a 1031 Exchange. A Section 1031 exchange is only available for property held as an investment, such as a house or apartment you have been renting out, or real estate used in a business.
- The old and new property must be registered/titled to the same taxpayer or entity. The owner could be an individual, LLC, partnership, trust, etc.
- To defer the entire gain, the replacement property must be of equal or greater value. Receiving cash or additional property (known as “boot”) does not disqualify the exchange. However, any “boot” received in the transactions will be subject to capital gains tax.
- You must use a “Qualified Intermediary or Exchange Facilitator.” The IRS requires that a Qualified Intermediary, aka a 1031 Exchange Accommodator or Facilitator, be used for the sale and purchase of real estate in order to preserve the 1031 exchange This intermediary must be a third-party to the transaction; cannot be you or someone related to you.
- Exchanges must meet two main time limits: 45 Day Identification Period and 180 Day Purchase Period. This means that once you sell the property, you have 45 days to identify another similarly priced property whose owner wishes to sell to you. After that, you have 180 days to close the deal.
- You have quite a few options in structuring the exchange:
- Delayed Exchange (the most common) – you sell your relinquished property first, then identify and purchase a replacement property within the prescribed time period (180 days).
- Simultaneous Exchange — you sell your old property and buy a new at the same time. However, a delay in closing can result in the disqualification of the exchange and trigger a capital gains tax and recapture of depreciation.
- Reverse or Forward Exchange – you buy a replacement property first, then sell the relinquished property. This can be especially advantageous in hot markets or in situations you need to act fast on a new listing.
- Construction/Improvement Exchange — you can add to or improve your replacement property as part of the exchange. The replacement property stays parked with an Exchange Intermediary during the new construction or improvements.
A useful strategy is to exchange rental properties in need of repair for newer properties that generate higher income. Read this post to find out how this works and why it’s a great way to make the most of certain real estate holdings.