What is A 1031 Exchange? A Detailed Explanation

What is a 1031 Exchange

If you’re thinking about selling or even buying real estate, you may have heard the term 1031 exchange come up before, but do you really understand what it is, and how to make it work best for you in terms of your real estate investment property? It’s fairly simple, if you understand the ins and outs of a 1031 exchange, and what it means come tax time.

How does a 1031 exchange work?

In simple terms, a 1031 exchange refers to Section 1031 of the Internal Revenue Code, but it’s a common term that comes up a lot in conversations with investors, title companies and real estate agents. There are certain things you need to do and not do to make a 1031 exchange effective, plus you need to think about working within specific time frames and know about any tax implications before you try it. 

Essentially, a 1031 exchange is a tax break that allows you to sell a property you already have that’s for investment or business purposes and swap it out for a new one you plan on using in the same way. When you’re able to do this, you defer the capital gains tax on the sale of your original property. To make it work, you don’t get the proceeds from the sale of your original property, but rather they’re held in escrow by a third party until you’re ready to use that money to purchase a new property.

What qualifies for 1031 exchange?

Not all properties are eligible, so keep that in mind too, as the IRS must consider the properties “like-kind” in order to defer capital gains taxes. This could mean exchanging properties such as an

  • Apartment building for land
  • Strip mall for a ranch
  • One business for another

Usually, it’s just for investment and business properties, but under certain conditions you may be able to apply it to a former principal residence, but usually only when you’ve rented it out for a while and can consider it an investment property. If you’re following all the rules correctly, you can do 1031 exchanges multiple times and continue to roll the gain from one real estate investment property to another and you don’t have to pay the capital gains tax on it for the time being. 

What’s the time limit of a 1031 exchange?

Usually, you have 45 days to sell your original property and designate a new property you plan to acquire in writing. Again, you can’t receive the money from the sale, as it must go to an intermediary to hold onto for the time being, however, it  does get a little tricky, especially if you don’t have a new property in mind that qualifies and you want to buy, so in this case you’ll do what’s called a delayed exchange. With a delayed exchange you get 180 days to sell the original property and close on a new one. Again, a 1031 exchange isn’t necessarily a way to avoid paying taxes, but rather it helps you postpone the capital gains tax to a later time, so you’ll want to keep that in mind for the future if you plan on using it to your advantage. 

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