1031 Exchange Reference Guide

November 4, 2020


1031 Exchange Reference Guide

If you own investment property and are thinking of selling it and buying another piece of property, then you need to know about the 1031 tax-deferred exchange. The 1031 exchange is a procedure that allows you, as the owner of investment property, to sell it and buy a similar property — all while deferring capital gains tax. 

But what, exactly, is the 1031 exchange, and how can it benefit you? Here, we’ll take a closer look at the 1031 exchange, including its rules, concepts, and the definitions you should know if you’re thinking of getting started with this type of transaction. 

What is a 1031 exchange? 

Also referred to as a Starker Exchange or a like-kind exchange, a 1031 tax-deferred exchange is a technique that is used to defer the tax implications on real estate capital gains, that is allowed through Section 1031 of the IRS Service Code. 

In order to defer capital gains tax using the 1031 exchange, there are a number of requirements that must be met:

  • The property must be used for investment, trade, or business that is exchanged or relinquished for a similar, like-kind property 
  • The transaction requires the use of a neutral third party, like a tax-deferred exchange intermediary or accommodator 
  • Within 45 days of the relinquished property being sold, up to three replacement properties must be flagged — and it must be purchased within 180 days 
  • All proceeds from the sale of the relinquished property must be reinvested in a replacement property or properties of equal or greater value than that of the property that was sold 

Who all is involved in a 1031 exchange? 

In this type of transaction, there are three key players: 

  1. IRS Section 1031 of the IRS Service Code, which will define the steps that need to be taken when conducting this type of exchange. 
  2. The Investor/Taxpayer/Exchangor, the party selling the investment property and trying to defer the tax liability on its capital gains
  3. The intermediary, who is a neutral, third party authorized tax-deferred exchange facilitator 

What does a 1031 exchange involve? 

A 1031 exchange involves investment property that is used for an investment, or for trade or business — for instance, single-family rental homes, land, shopping centers, apartment buildings, office buildings, warehouses, and more. 

Property that qualifies for these types of transactions is held for investment purposes. To help determine this, the Internal Revenue Service will look at the intent of the property that is to be sold, how long it was held by the owner or owners, and what business said owner is in. 

When relinquishing or selling a property, you can replace it with up to three properties, valued at the same price (or higher). And keep in mind that like-kind replacement refers to the use, and not the type, of the property — giving you a great way to diversify the real estate holdings in your portfolio. 

Why is depreciation important to a 1031 exchange? 

Depreciation, the percentage of the cost of your investment property that can be written off every year, is designed to recognize the effects of wear and tear on your property. When your property is sold, capital gains taxes are calculated based on the property’s net adjusted basis (which is just a fancy way of saying your original purchase price plus capital improvements minus depreciation). 

If your property sells for more than its depreciated value, you may need to recapture the depreciation — in other words, the depreciation will be included in your taxable income you receive from the sale of your property. Since the size of the depreciation recaptured increases over time, a 1031 exchange may be a good idea to help you avoid the large increase in taxable income that may be headed your way otherwise. 

Interested in learning more about a 1031 exchange or selling your investment property? Contact us today to find out how you can make more money by selling with Reali. We’re here to help you navigate selling your home with ease. 

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