A 1031 exchange is an actual estate investment property swap that allows capital gains taxes to be deferred.
It’s named after Section 1031 of the Internal Revenue Code (IRC) and is used by real estate agents, title companies, and investors. It’s limited to like-kind properties and has tax implications and time frames.
The following content will explain a few rules about the 1031 exchange.
What Is Meant By the 1031 Exchange Rule?
The exchange1031 Rule is a tax-deferred exchange where one investment property is swapped for another, allowing tax-deferred growth.
It allows for frequent swaps without cashing out or recognizing capital gains, allowing for tax-deferred growth. The exchange can be done at any rate, with a lengthy capital gains rate of 15% or 20%, depending on income.
This tax is only paid if the exchange works out as planned.
1031 Exchange Rules and Timelines
Delay, three-party, or Starker exchanges involve swapping property between two people, with difficulty finding the exact property.
A qualified intermediary holds cash after selling property and uses it to buy replacement property, with two key timing rules to follow.
The IRS requires the designation of a replacement property indicating the property you wish to purchase within 45 days of your sale.
You can designate three properties if you close on one or more if they meet certain valuation tests.
The 180-day Rule in a delayed exchange requires closing on the new property within 180 days of the old property’s sale.
1031 exchanges also work with mortgaged property
Using real estate with an active mortgage for a 1031 exchange is also possible. The mortgage on the replacement property has to be equal to or higher than the mortgage on the selling property. The value difference is taxable and regarded as boot if it’s smaller.
Changes to 1031 Rules
The Jobs Act (TCJA) and Tax Cuts in 2017 changed the qualifying criteria for 1031 exchanges of personal property from franchise licenses, aircraft, and equipment to real property.
However, the TCJA full expensing allowance for certain tangible personal property may offset this change. The transition rule is specific to taxpayers.
1031 Exchanges Don’t Work to Downsize an Investment
The 1031 exchange rules mandate that the new investment property must be equal or greater in value to the selling property, and the proceeds must be used for full tax deferral. If not, the capital gains tax applies.
How to Report 1031 Exchanges to the IRS
To notify the IRS of a 1031 exchange, compile and submit Form 8824 with your tax return in the exchange year. Provide descriptions, dates, relationships, property values, adjusted basis, and assumed liabilities.
Complete the form correctly to avoid penalties and potential tax bills.
Which is not allowed in a 1031 exchange?
Exchanges of real property are the only transactions for which Section 1031 still applies under the Tax Cuts and Jobs Act; the rules for 1031 exchange do not govern personal or intangible property exchanges.
A real estate exchange held largely for sale is not considered a like-kind exchange.