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1031 Exchange Rules: A Current List

A 1031 exchange involves selling one property and using the proceeds of that sale to purchase another similar property. The Internal Revenue Service (IRS) calls these “like-kind exchanges,” and it points out that these purchases come with significant tax benefits. 


Taxes are involved in a typical property sale, but in a 1031 exchange, you’re not required to recognize a gain or loss. 


While a 1031 exchange could help you diversify your portfolio without spending a lot on tax bills, several regulations are enforceable. Understanding the rules could ensure you handle these transactions safely. 


How Is 1031 Exchange Defined?


The IRS has a specific definition of a 1031 exchange, found under Section 1031 of the Internal Revenue Code. It is defined as swapping real investment or business property that is “like” or similar, allowing for the deferral of capital gains taxes.


There is no limit on how many times you can do a 1031 exchange, but you must ensure you do it correctly. If you don’t follow the guidelines precisely, you may be liable to pay capital gains taxes.


Types of 1031 Exchanges


Most 1031 exchanges are delayed. A simultaneous exchange means that the relinquished property and the newly acquired properties both close at the same time. Since this requires significant orchestration, most 1031 exchanges fit the delayed definition. 


This means the original property is sold, and the investor has 180 days to buy a new property. The funds from the sale are held with the intermediary during that time.


A reverse exchange occurs when the new property is purchased prior to the sale of the existing property. A construction or improvement 1031 exchange involves a new property that is built or improved according to investor need. 


Core 1031 Exchange Rules 


While any investor must understand all of the 1031 exchange rules, the following sections can help you know how some of the common regulations work. 


Property Must Be Considered ‘Like-Kind’

In a legal 1031 exchange, one property is sold, and another similar property is purchased. Per IRS rules, the “like-kind” term refers to the property’s nature or character. Its grade or quality doesn’t matter.


For example, you couldn’t sell property in Mexico and buy something within the United States. The IRS states that property outside the U.S. is not “like-kind” to property within the country. 


But “like-kind” can have a more liberal interpretation than some people might think. For example, you may be able to swap a ranch for an office building, or you could exchange a residential house for a vacant lot. Most forms of real estate will be considered “like-kind” to other forms of real estate.


Time Frames Must be Met 

The IRS defines two very important deadlines for 1031 exchange transactions. Missing one or the other could mean that your sale is taxable. 


These are the two deadlines you should know:


  • 45 days: This time frame refers to the time between when you sold the property and when you identified a replacement. That identification must be in writing and delivered to the property owner and the person handling your 1031 exchange.  Because of this somewhat tight time frame, it’s wise to plan ahead when anticipating a 1031 exchange. This gives you more leeway to identify potential properties. Identify a few properties in case things don’t work out with your top choice.


  • 180 days: This time frame refers to the time between when you sold the original property and closed the new deal. While most people calculate this quickly to be six months, make sure you check the exact date this falls. The IRS will have a firm deadline based on the day count, not a rough month estimation.


The Property Must Be of Similar Value 

A 1031 exchange should involve property of similar value. For example, if you’re selling property with depreciating items, you should purchase one with similar assets. 


If you purchase an item that’s of smaller value, you can get assets in return (like cash). However, that secondary item could be considered taxable per the IRS rules. To get the full tax benefits of your sale, you must buy something that is of equal or higher value. 


Other 1031 Exchange Rules to Keep in Mind 


While the 1031 exchange rules we’ve listed above are the most stringent and common, they’re not the only ones you should know about. The following regulations are part of a successful transaction:


Qualified Intermediary 

The IRS explains that most people use an intermediary to facilitate a successful 1031 exchange, as this is necessary for a delayed 1031 exchange. In addition, hiring someone to help you can ensure that you don’t accept the funds from a sale too early and face tax consequences as a result. Instead, the intermediary holds the funds in trust and uses them to purchase the replacement property. 


Generally, the qualified intermediary holds the profits from the sale of the relinquished property in escrow. When the time comes, those funds are used to acquire the new property. At no point do you receive the funds.


Exchanges

Sometimes, investors purchase a property worth less than the one they’ve sold. This can trigger a “boot.” The most common form of boot is cash, but you might also get things like installment notes or debt relief. 


When you get a boot, it triggers a partial exchange. That means you won’t get a full tax deferral for the sale of the property. Instead, you’ll be required to pay taxes on the profits you took away via the boot.

 

Understand 1031 Exchange Rules 


A 1031 exchange can only save you money if you follow the rules to the letter. Parsing IRS language isn’t easy for anyone, including experienced investors. 


Let the qualified team at 1031 Pros help you with these delicate transactions. We’ve handled more than 20,000 audit-free exchange transactions, and we’ve saved clients more than $500 million in capital gains tax. Contact us to get started. 


References


Like-Kind Exchanges: Real Estate Tax Tips. (November 2023). Internal Revenue Service. 


Common Nontaxable Exchanges. Internal Revenue Service. 


Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service. 


2023 Instructions for Form 8824. (2023). Internal Revenue Service.

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