Understanding the 1031 Exchange: Should You Use It When Buying & Selling Real Estate?

If you're trying to sell a property while buying another property, you've probably heard of the "1031 exchange." A 1031 exchange is a like-kind property exchange under which property owners can avoid having to pay taxes for simply "exchanging" one property for another. Instead, taxes are only paid when the owner eventually sells for cash. It only applies to certain sales—and it has to be handled correctly from the start. Keep reading to take a deeper look and the what, how, and why of doing a 1031 exchange.

For informational purposes only. Always consult with a licensed real estate professional before proceeding with any real estate transaction.

What is a 1031 Exchange?

Under a 1031 exchange, a person "exchanges" one property for another like-kind property. Like-kind property means a property of the same nature—for example, a rented condominium for another rented condominium—though the definition of like-kind property can encompass almost any exchange of real properties within the U.S. Effectively, rather than a person getting cash for the property they're selling and using it to buy the property they're buying, they're using an escrow company (a third-party intermediate) to buy one property with another.

The advantage to a 1031 exchange is that the capital gains aren't realized. The seller doesn't need to pay income taxes because they didn't receive any money; they just exchanged one property for another.

The easiest way to understand this is an example. A person owns a rental property that they bought for $200,000. They would like to sell it for $300,000 and buy a property that's $600,000.

Without a like-kind exchange, the owner:

• Sells the property for $300,000.
• Pays capital gains tax for the $100,000 they made on that property.
• Puts a $300,000 down payment on the new property.

But with a like-kind exchange, the owner:

• Sells the property for $300,000, which goes directly to an escrow company.
• The escrow company puts a $300,000 down payment on the new property.
• The owner doesn't pay any capital gains tax on the $100,000 in value they made.

There's a significant advantage to doing things this way. The capital gains aren't "realized," so the capital gains taxes aren't "realized," either. Exchangers can roll a smaller property into a larger property, exchange developed properties for undeveloped ones, exchange a single large rental property for several smaller ones, swap real estate investments for similar ones at a new location when the investor is moving, and more, all without paying capital gains taxes until they sell a property for cash.

How Do You Do a 1031 Exchange?

There are important rules for a 1031 exchange that must be followed. To do a 1031 exchange, the seller can never be in possession of the proceeds of the original sale. This would be realizing the gain. A 1031 exchange has to be managed by an escrow company. If the exchanger is downsizing and will have proceeds, known as "boot," they will be distributed the proceeds, and they may need to pay capital gains tax on that. This also applies to mortgages on either property—if the mortgage on the property being bought is lower than on the property being sold, the difference is treated as income or "boot" to the exchanger and may be subject to tax.

Finally, and importantly, exchangers have 45 days from the time of sale to find a property with which to complete the exchange. If they don't identify and designate another property within those 45 days for the escrow company to purchase, they may find themselves on the hook for the capital gains tax. They do have 180 days from the time of sale to close on that property (or properties; there may be up to three, depending on whether they meet the right criteria).

Can You Do a 1031 Exchange for Your Primary Residence?

In most circumstances, no. The 1031 exchange is reserved for properties used for business or investment properties, such as commercial or rental properties, not primary residences. However, the IRS has provided a way to convert a primary residence into a rental property that the owner can then use in a 1031 exchange. This is known as Revenue Procedure 2005-14, and it allows owners to combine the 121 Exclusion on the sale of primary residences with the Section 1031 deferral of capital gains tax.

When selling an owner-occupied property that the owner has lived in for two years, the owner doesn't need to pay tax for the first $250,000 in gains (if filing as an individual) or the first $500,000 in gains (if filing as a married couple). This is known as the 121 Exclusion, an exception for capital gains tax. Most homeowners won't need to worry about capital gains tax on their primary residences because the profit will generally fall below this threshold. But situations can arise when an owner would be making an amount beyond the 121 Exclusion threshold from their currently owner-occupied home, especially if they're in a hot real estate market or if they've held their home for a long time. Because of that, a 1031 exchange to defer capital gains tax on the rest of the capital gains could be beneficial—it all depends on how much the owner bought the home for and how much they're trying to sell it for now.

In order to take advantage of both the 121 Exclusion and the 1031 exchange, an owner moves out of their primary residence and holds the former residence as an investment property for a minimum of 12–18 months. This demonstrates to the IRS that the intent at the time of sale was to hold the property as an investment property. Because the residence is now an investment property, it qualifies to be exchanged via Section 1031. However, so long as it was used as the owner's primary residence for at least two of the previous five years, it will also qualify for the 121 Exclusion. The first $250,000–$500,000 of the gains will be tax-free under Section 121, and the rest of the gains will have the capital gains tax deferred under Section 1031.

A 1031 exchange is a pretty specific type of exchange, and it's generally most beneficial for individuals who want to exchange business real estate rather than owner-occupied real estate. But if a transaction falls within its domain, it can often help significantly. The best way to find out more is to contact Kevin Kling today.

For informational purposes only. Always consult with a licensed real estate professional before proceeding with any real estate transaction.