What Is a 1031 Exchange and How Does It Work?

What Is a 1031 Exchange and How Does It Work?

What Is a 1031 Exchange?

A 1031 exchange allows a real estate owner to sell qualifying property and reinvest the proceeds in other qualifying real estate while deferring taxes that might otherwise be due from the sale.

The name comes from Section 1031 of the Internal Revenue Code. You may also hear it called a “like-kind exchange” or “tax-deferred exchange.”

A 1031 exchange does not eliminate the tax. Instead, it generally postpones recognition of the gain by carrying it into the replacement property.

How a 1031 Exchange Works

Most 1031 exchanges follow five basic steps:

• • Plan the exchange before selling.
    Speak with qualified tax, legal and exchange professionals before the sale closes.

• • Engage a Qualified Intermediary.
    A Qualified Intermediary, commonly called a QI, must generally be appointed before the relinquished property is sold. The QI receives and holds the proceeds so the investor does not take possession or control of the money.

• • Sell the relinquished property.
    At closing, the proceeds are transferred to the QI rather than to the investor.

• • Identify replacement property within 45 days.
    The investor must identify potential replacement property in writing within 45 calendar days after transferring the relinquished property.

• • Acquire the replacement property within 180 days.
    The replacement property must generally be acquired within 180 calendar days of the sale—or by the applicable tax-return deadline, including extensions, if that date comes first.

The 45-day and 180-day periods begin at the same time. The 180-day period does not begin after the identification period ends.

What Does “Like-Kind” Mean?

In a real estate exchange, “like-kind” is broader than it sounds. The properties do not need to have the same appearance, use or quality.

For example, an investor may be able to exchange:

• • An apartment building for a retail property

• • Vacant land for a rental property

• • An industrial building for an office property

• • One investment property for multiple replacement properties

Both the relinquished property and the replacement property must generally be real property held for investment or productive use in a trade or business.

A primary residence, property held primarily for resale, stocks, bonds and other securities generally do not qualify.

How Much Must Be Reinvested?

An exchange can still qualify if an investor does not reinvest all the proceeds, but part of the transaction may become taxable.

As a general guideline, an investor seeking full tax deferral typically acquires replacement property of equal or greater value and reinvests all net proceeds from the sale. Debt, cash contributions, transaction expenses and other factors can affect the calculation.

Cash or other nonqualifying value received in the exchange is commonly called boot. Boot may trigger recognition of some taxable gain.

Because these calculations depend on the specific transaction, investors should review the proposed exchange with a qualified tax professional before closing.

Why Investors Use 1031 Exchanges

A properly structured exchange may allow an investor to:

• • Preserve more equity for reinvestment

• • Move into a different property type or market

• • Consolidate several properties into one

• • Divide one property into several investments

• • Adjust income, management responsibilities or diversification

• • Continue building a real estate portfolio without recognizing the entire gain at the time of sale

Whether an exchange is beneficial depends on the investor’s objectives, tax position and available replacement properties.

Common Mistakes to Avoid

A 1031 exchange can fail if it is not structured correctly. Common problems include:

• • Waiting until closing to contact a QI

• • Receiving or controlling the sale proceeds

• • Missing the 45-day identification deadline

• • Missing the 180-day acquisition deadline

• • Identifying replacement property incorrectly

• • Purchasing property that does not qualify

• • Assuming every dollar of gain will automatically be deferred

• • Choosing a replacement property primarily to meet a deadline rather than because it is a sound investment

The deadlines are strict, so advance planning matters.

The Bottom Line

A 1031 exchange can be a valuable tool for real estate owners who want to sell qualifying property and reinvest in other real estate while deferring recognition of taxable gain.

The basic process is straightforward:

Sell qualifying property → transfer the proceeds to a Qualified Intermediary → identify replacement property within 45 days → complete the acquisition within 180 days.

The details of each exchange can be complex. Investors should involve a Qualified Intermediary and experienced tax and legal professionals before the sale closes.

This article is provided for general educational purposes only and does not constitute tax, legal, securities or investment advice. Comterra Invest does not determine whether a particular transaction or property qualifies for Section 1031 treatment. Consult qualified tax, legal and financial professionals regarding your individual circumstances.