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Guide to 1031 Exchange: How a 1031 Exchange Works

Real estate investors can use the 1031 exchange to sell and buy investment properties while avoiding capital gains tax liability.
What Is a 1031 Exchange?

In real estate and tax law, a 1031 exchange is when you replace one investment property with another in a short amount of time in order to avoid capital gains taxes and depreciation recapture. Section 1031 of the US Internal Revenue Code states that any income generated from selling an investment property will incur capital gains taxes. However, if the seller invests that income in a new property that is of equal or greater value, the seller can avoid capital gains taxes.
Also known as a like-kind exchange, 1031 exchanges must be made with similar properties to be recognized for tax deferral by the IRS. Real estate investors that sell and buy investment properties in a 1031 exchange must use a qualified intermediary to transfer finances from the sold property to the new property.

What Are the Requirements for a 1031 Exchange?

The 1031 exchange does not apply to primary residences but it can apply to rental properties, vacation homes, apartment buildings, and business properties. Beyond those rules, there are four requirements that an owner’s investment property exchange must meet to qualify for a 1031 deduction.

• Property value: The market value of the new investment property must be of equal or greater value than the relinquished property.

• Use of funds: The property owner must use all of the income they received from selling the relinquished property towards the purchase of the new exchange property.

• Property type: Both the sold property and the replacement property must be considered like-kind properties. For example, residential rental properties should be exchanged for other rental properties, and commercial properties can be exchanged for other commercial properties.

• Timeline: A 1031 property exchange must occur within about a six-month time frame to be valid. The potential replacement property must be identified within 45 days of the sale of the original property. The investor must then buy the replacement property within 180 days. For this reason, the 1031 exchange is also known as a delayed exchange.

How Does a 1031 Exchange Work?

The 1031 exchange allows taxpayers to perform a tax-deferred exchange of investment properties, meaning that capital gains taxes are not owed on a property sale.

1. The investor selects a qualified intermediary. Once the investor’s relinquished property is under contract, they must decide who will act as their qualified intermediary. This person acts as a trustee who handles the exchange of funds during the entire transaction. They hold the money from the sale of the relinquished property when it sells, and disburse these funds to the investor when they buy their new property.

2. The investor relinquishes their original property. The first step in this process is for the seller who intends to perform a 1031 exchange to sell their property. On the day that their original property closes and the new owner take possession of it, the 1031 exchange timeline begins.

3. The investor finds their replacement property within 45 days. The investor must identify their proposed replacement property within 45 days of selling the relinquished property. Failure to do this within the 45 day period will cancel the 1031 exchange and they will have to pay capital gains taxes on any income generated from this exchange.

4. The investor closes on the replacement property within 180 days. The investor must close on their new investment property within 180 days of relinquishing their original property (135 days after finding their replacement property). The qualified intermediary will transfer all the sale proceeds from the relinquished property to purchase the new property. The investor covers the difference if the new property is of a higher value.

5. The investor notifies their tax advisor. Once the 1031 exchange is complete, the investor should notify their tax advisor of the transaction so that they can properly document it on their income tax return.

Written by MasterClass

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