Understanding 1031 Exchanges and Property Requirements

A 1031 exchange, or the like-kind or tax-deferred exchange, is a real estate transaction allowing you to defer capital gains...

Posted in 1031 exchanges, Investors
on May 4, 2023

Understanding 1031 Exchanges and Property Requirements

A 1031 exchange, or the like-kind or tax-deferred exchange, is a real estate transaction allowing you to defer capital gains taxes by exchanging one investment property for another.

In 1031 exchanges, the proceeds from the initial property are reinvested in a new property, allowing you to defer paying capital gains taxes on the profit from the sale of the initial property.

To learn more about 1031 exchanges, let’s discuss the four types:

Simultaneous Exchange

This is the most straightforward type of exchange, where the replacement property is purchased simultaneously as the relinquished property is sold.

Delayed Exchange

In this exchange, you sell your relinquished property and have 45 days to search for potential replacement properties. Then, you must purchase that replacement property within 150 days of selling the relinquished property.

Reverse Exchange

In a reverse exchange, you buy the replacement property before selling the relinquished property. This type of exchange is more complicated and typically requires an Exchange Accommodation Titleholder (EAT) to hold title to the replacement property until the relinquished property is sold.

Improvement Exchange

In this exchange, you allot some of the proceeds from selling the relinquished property to improve the replacement property. The value of the improvements must at least be equal to the deferred gain.

Each type of 1031 exchange property has rules and requirements that you must follow to qualify for a tax-deferred transaction.

1031 exchanges could be a complicated process, but it can be helpful for you because it can help you defer capital gains taxes, diversify your portfolio, buy more profitable properties, and continue reinvesting your proceeds.

What Qualifies a Property for 1031 Exchanges?

If you own an investment property, opting for 1031 exchanges is wise because the process will help you sell it and buy another building while deferring taxes, like state and federal capital gains taxes. But before qualifying for it, your investment property must meet several requirements, like:

Like-kind

The property you’re selling (the relinquished property) and the property you’re buying (the replacement property) must be of similar nature or character. For example, you can exchange a commercial property for another commercial building but not a residential one.

Investment or business property

The relinquished and the replacement property should be for investment or business purposes. Properties held primarily for personal use, such as a primary residence or a vacation home, do not qualify as 1031 exchange properties.

Held for a minimum period

You must have held the property being sold for a minimum period of 12 months to qualify for 1031 exchanges.

Qualified intermediary

A qualified intermediary, often a third party, facilitates the exchange process and manages the proceeds during the transaction.

Timeline

You have 45 days to close the purchase of your first property and 180 days between closing your first property’s sale and closing the replacement property’s purchase.

Lastly, you’ll have to remember that there are additional rules and requirements that you should comply with to qualify for 1031 exchange properties. One of which is consulting with a qualified tax and legal professional to ensure compliance with all applicable regulations set by the IRS.

Sources:

IRS.gov: “Like-Kind Exchanges – Real Estate Tax Tips”: https://www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real-estate-tax-tips

Investopedia: “1031 Exchange”: https://www.investopedia.com/terms/1/1031exchange.asp