What to Know About 1031 Exchanges

A 1031 exchange (a like-kind exchange) is a swap—one investment or business asset for another.  While most swaps are taxable as a sale, if you stay within the perimeters of Section 1031 of the Internal Revenue Code, you’ll either have no tax or limited tax due at the time of the swap.

Essentially, you can change the form of your investment without recognizing a capital gain which allows your investment to continue to grow tax deferred. Because there’s no limit on how frequently you can do a 1031 exchange, you can roll over the gain from one piece of investment real estate to another to another and so on.  Although you may have a profit on each swap, you avoid tax until you actually sell the investment for cash down the road.

Here are a few things to know about a 1031 exchange:

• A 1031 exchange is not for personal use property.

Section 1031 is only for investment and business property, so you can’t swap your primary residence for another home.

• But some personal property qualifies.

Most 1031 exchanges are of real estate but exchanges of personal property can qualify too.  

•  “Like-kind” is broad.
  Most exchanges must merely be of “like-kind”–a phrase that doesn’t really mean what you think it does.  For example, you may exchange a ranch for a strip mall—the rules are surprisingly liberal. Additionally, you could even swap one business for another.  But again, be wary of traps.
• Delayed exchanges can work too.

         The chances of finding someone with the exact property you want who also wants the exact property you have are quite slim.  Because of that, the vast majority of exchanges are delayed.  In a delayed exchange, you must have an intermediary who holds the cash after you “sell” your property and uses it to “buy” the replacement property for you.  If you receive the cash personally, the 1031 characterization is lost.  
Within 45 days of the sale of your property, you must also designate replacement property in writing to the intermediary, specifying the property you wish to acquire.  The good news is that you can  designate multiple properties so long as you eventually close on one of them.   

It is important to know that you must close on the new property within 180 days of the sale of the old property.  Note that the two time periods mentioned run concurrently, which means time begins to run the day your property sale closes.  For example, if you designate replacement property exactly 45 days after you close on your property, you’ll have exactly 135 days left to close on your replacement property.

If you have cash left over after the intermediary acquires the replacement property, the intermediary will pay it to you at the end of the 180 days. That cash will be taxed as partial sales proceeds from the sale of your   property.

As you can see, a 1031 exchange, while being a very beneficial tool, can be daunting and rule-intensive.  Before jumping in head-first, seek out a legal profession who can guide you through the process.