Understanding 1031 Exchange

A 1031 exchange is a real estate transfer in which one investment property is exchanged for another, allowing capital taxes to be deferred.

Real estate agents, title firms, investors, and soccer mothers all use the word derived from Internal Revenue Code (IRC) Section 1031.

Some individuals even insist on using it as a verb, as in “Let’s 1031 that building and replace it with another.”

In effect, you can alter your investment type without cashing out a capital gain, as defined by the IRS. As a result, your real estate venture can continue to grow tax-free.

There is no benchmark on how many times you may perform a 1031 exchange as per 1031 exchange rules. You may roll over your profit from one investment property to another, another, and another.

You can defer paying tax until you sell for cash years later, even if you make a profit on every transaction.

Then, if all goes according to the exchange plan, you’ll only have to pay one tax: a long-term capital gains rate (15% or 20%, depending on income—and 0% for some lower-income investors).

Exchange Qualification

Most interactions must be of like-kind to qualify—an ambiguous term that doesn’t always imply what you think it implies. An apartment complex may be traded for raw land and a ranch for a strip mall.

The rules are very lenient. You may even trade businesses with one another. There are, however, traps for the unwary. The 1031 exchange is intended for investment and company property, but it can also apply to a former primary dwelling in certain circumstances.

There are additional methods to use 1031 for vacation home swaps (more on that later), but this loophole is considerably less than it formerly was. The most important qualification for a 1031 exchange is that both the properties must be within the geographical jurisdiction of the United States.

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Using Swapped Property

You can’t move in right away if you intend to utilize the property you traded as your new second or even primary residence.

The IRS established a safe harbor rule in 2008, stating that it would not question whether a replacement house qualified as an investment property for Section 1031 purposes.

To meet the safe harbor, in each of the two 12-month periods following the exchange, do the following:

• Rent the unit for at least 14 days or more at a fair rental price.
• During the 12-month period that the housing unit is rented at a fair rental, your personal usage of the swapped unit cannot exceed the greater of 14 days or 10% of the number of days that the dwelling unit is rented at a fair rate.

Furthermore, you cannot immediately convert the new property to your principal residence and take advantage of the $500,000 exception after successfully switching one vacation or investment property for another.

If you buy a property in a 1031 exchange and then try to sell it as your primary residence, the exclusion will no longer apply for the five-year period starting from the date you bought the property in the 1031 exchange. To put it another way, you’ll have to wait a lot longer to take advantage of the main home capital gains tax deduction.