A 1031 exchange is a savvy real estate investor tax strategy that can help grow portfolios and increase net worth at faster, more efficient rates. But what is a 1031 exchange, and what are the rules to qualify? Here is a brief overview of how 1031 exchanges operate, the eligibility window, and the varying rules for attempting a 1031 exchange.
What Is a 1031 Exchange?
A 1031 exchange is swapping one real estate investment property for another, allowing deferment for capital gains taxes. Named from Section 1031 of the Internal Revenue Code (IRC), the 1031 exchange is mainly for real estate agents, title companies, and investors.
The IRC Section 1031 has multiple facets that real estate investors must understand before using it. For example, exchanges only occur with like-kind properties, and the IRC rules limit its uses to vacation properties. Furthermore, other tax implications and time frames can factor in.
Eligibility for a 1031 Exchange
A 1031 exchange is exclusively for property for productive use, including in trade, business, or investment. Furthermore, any property held for investment purposes qualifies for 1031 treatment, including commercial buildings, vacant lots, apartment buildings, and single-family homes.
Property primarily for personal use does not qualify for tax deferral under Section 1031; this includes primary residences and second homes. However, some personal properties have potential 1031 exchange qualifications. Part of what qualifies for a 1031 exchange includes the following:
- Limited liability companies
- C and S corporations
- Other taxpaying entities
1031 Exchange Rules
When attempting a 1031 exchange, clients must understand the rules before making the swap. Firstly, clients should have familiarity with the IRS’s definition of a 1031 exchange, along with having eligible properties for a successful attempt. Furthermore, clients must familiarize themselves with non-qualified properties held primarily for sale, securities, or other evidence of indebtedness.
Another rule is to review the five common types of 1031 exchanges:
- Delayed exchange
- Delayed/simultaneous exchange
- Delayed build-to-suit exchange
- Delayed/simultaneous build-to-suit exchange
- Delayed reverse exchange.
Lastly, replacement properties must have equal or greater value than those sold, become identified within 45 days, and become purchased within 180 days.
1031 exchanges allow real estate investors to defer paying capital gains tax. This allows investors to use the proceeds to purchase replacement real estate, similar to having an interest-free loan from the IRS.