You may have heard people talk about a 1031 Exchange in real estate discussions.
People use this tool to defer capital gains tax after they sell a piece of real estate, thus leveraging their money.
The 1031 Exchange Explained
Typically, when an investment asset is sold, the owner is taxed on capital gains. However, Section 1031 of the Internal Revenue Code provides an exception: If a seller replaces a non-owner-occupied investment property with a like-kind (same or higher value) property, the owner can defer paying taxes on capital gains.
The idea behind a 1031 Exchange is that the taxpayer’s investment is fundamentally the same — only the form has changed — and it would be unfair to tax what is only a gain on paper.
Using a 1031 Exchange Multiple Times
There’s no limit to the number or frequency of 1031 Exchanges an investor can do. Also, you can sell one property and acquire multiple properties providing the fair market value of the replacement properties does not exceed 200% of the fair market value of the exchanged property.
Investors also have the option of exchanging a property for up to three like-kind replacement properties regardless of fair market value. This is referred to as the “3 property rule.”
A 1031 Exchange can happen simultaneously, but in the vast majority of cases the exchange is delayed. This involves a “qualified intermediary” who handles the transfer.Under these circumstances, a 1031 exchange has two crucial time limits.
First, the seller must identify a replacement property no more than 45 calendar days after the sale date. Second, the seller must obtain title to the replacement property no more than 180 days calendar days after:
- a) the first property was sold or…
- b) the due date of the seller’s tax return for the year in which the first property was transferred, whichever occurs first.
For Investment and Business Property Only
Keep in mind that a 1031 Exchange isn’t for personal use. The provision is only for investment and business property, so you can’t swap your primary residence for another home.