What Is A 1031 Exchange In Real Estate?

When considering selling an investment property and purchasing another, you should be aware of the 1031 tax-deferred exchange. This process permits an investor to sell an investment property and buy similar property while delaying capital gains tax.

A 1031 exchange is named after Section 1031 of the United States Internal Revenue Code. You can avoid paying capital gains taxes when you sell an investment property and reinvest the earnings within specific time constraints in a property or properties of like kind and equal or greater worth. 

If you own commercial real estate and are wondering, “what is a 1031 exchange in real estate?”, keep reading to learn more about 1031 exchanges.

The Role Of A Qualified Intermediary (QI)

QIs are people or companies that assist with the 1031 exchange by retaining the cash until it is transferred to the new property owner. There can be no other formal relationship between the qualified intermediary and the parties exchanging property.

When Does The 1031 Rule Change?

Prior to the TCJA’s approval in December 2017, some personal property transfers, such as franchise licenses, airplanes, and equipment, qualified for a 1031 exchange. Only real property (or real estate) is now eligible as defined by Section 1031.

However, the TCJA’s full expensing allowed for certain tangible personal goods may help to compensate for this change in tax law. TCJA includes a transition rule that enables a 1031 exchange of qualified personal property by December 31, 2017, if the original property is sold or the replacement property is acquired by then. 

The transition rule is unique to the taxpayer and did not allow a reverse 1031 exchange, in which the new property was purchased before the old property was sold.

Types Of 1031 Exchanges

The most prevalent types of 1031 exchanges employed by real estate investors are the following:

  • A delayed exchange occurs when one property is sold (or relinquished), and a replacement property (or properties) is purchased within the timeframe allowed.
  • The replacement property is purchased simultaneously as the current property is sold in a delayed/simultaneous exchange.
  • The replacement property is purchased before the current property is relinquished in a delayed reverse exchange.
  • The current property is replaced with a new property built to suit the investor’s needs after a delayed build-to-suit exchange.
  • A build-to-suit exchange is delayed or simultaneous with the built-to-suit property purchased before the current property is sold.

What To Remember When Using A 1031 Exchange In Real Estate

Tax-deferred exchanges involve planning ahead of time. The following are the three main 1031 exchange regulations to follow:

The value of the replacement property should be equal to or greater than that of the one being sold.

To maximize a 1031 exchange, real estate investors should choose a replacement property—or several replacement properties—equivalent to or better in value than the property being sold. There are three options for doing so:

  • Select a max of three properties, regardless of their worth, or
  • If the value of all your properties does not exceed 200 percent of the property being replaced, you are free to identify as many properties as you like.
  • Identify as many properties you want as long as they are worth at least 95% of the property being replaced.

Replace the property within 45 days of its expiration.

When completing a 1031 exchange, real estate investors must plan. Because the IRS only gives you 45 days to find a replacement property for the one you sold. However, to receive the greatest deal on a replacement house, experienced real estate investors don’t wait until their current property has sold before beginning their search. 

Imagine calling a real estate broker with a property for sale and informing them that they only have two days to find a replacement. The chances of getting a good deal on the house are extremely slim.

Within 180 days, a replacement property must be obtained.

The replacement property must be purchased and closed no later than 180 days after the current property was sold. Keep in mind that 180 days is not the same as six months. To calculate the 180 days, the IRS counts each day, including weekends and holidays (including federal holidays).

Using 1031 Exchange With Stocks

The IRS has categorized 1031 exchange stock to real estate as being utilized exclusively for real estate investments. The Revenue Act of 1921 included a provision governing 1031 exchanges, which went into effect in 1921. Former U.S. President Donald Trump most recently revised it with the Tax Cuts and Jobs Act of 2017. 

Only investments that fit the IRS’s definition of “real property” are eligible for a 1031 exchange under this statute. The IRS does not regard stocks, bonds, or other assets to be real property.

In spite of the fact that you cannot delay stock earnings with a 1031 exchange, there are other options available to put you in a better position to pay less in taxes based on the success of your assets. To understand how your investments relate to state and federal tax rules, you should consult a tax professional or accountant.

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