A real estate investment involving a 1031 exchange allows the investor(s) to postpone paying any capital gains taxes on a property sale until it’s more advantageous. Anyone planning to make such an investment should understand how 1031 exchanges work. The simplest way to define a 1031 exchange is as a swap of one real estate property for another. However, there are numerous 1031 exchange rules, beginning with a requirement that both properties must be in the United States. To take full advantage of the benefits of this type of investment, one must understand the 1031 tax exchange rules as clearly and completely as possible. Here’s a look at some of the basic rules:
One of the most important Section 1031 exchange rules centers on the definition of “like-kind” property. For a property transaction to qualify for a 1031 exchange, the new property must be a like-kind property. Like-kind simply means the properties sold and purchased must be of the same type. Under IRS rules, this means the new property must have the “same nature or character,” though they can differ in quality or grade. Simply put, the two properties must have some type of common purpose.
However, this does not mean you can only exchange very specific types of property (i.e., a hair salon for a hair salon). Nor must a transaction consist of a single piece of real estate for another piece of real estate. You can sell multiple parcels to obtain a single, larger parcel, or vice versa. As long as you are purchasing like-kind real estate, these types of transactions will meet this qualification.
Another of the important 1031 real estate exchange rules has to do with value. Under the IRS tax code, like-kind exchanges allow the investor to postpone paying costly capital gains taxes only if the newer property in which the investment is being made has a market value greater or equal to the sold property.
Put more simply, for a property swap to qualify as a 1031 exchange, you must use every dollar’s worth of value from your existing property to purchase the new one. If the new property is not valued highly enough, the transaction won’t meet the 1031 property exchange rules, and the profit from the sale of your original property will be subject to capital gains tax. While this may initially seem like a limiting factor in deciding whether to make the investment, it works to the benefit of the investor over the long term. Your overall investment in a new property will be larger each time you are involved in a 1031 exchange, and so your appreciation is building from a larger base. This means your profits will be compounded over the years. It benefits the investor to meet the greater or equal value requirement because by definition his or her portfolio grows with each qualifying transaction.
The 1031 property exchange rules do not allow transactions involving personal property. You cannot use your investment portfolio to purchase a home to live in. Likewise, you cannot exchange your current home for another home.
Under some circumstances, it may be possible to use a 1031 exchange to swap second homes or vacation homes. You must be able to prove that these are also investment properties
It is important to note that swaps of personal property other than real estate no longer qualify for 1031 exchanges, either. Before tax reform laws went into effect in 2018, some types of personal property (such as aircraft, franchise licenses and equipment) qualified. Only real estate transactions are eligible now.
A boot occurs when sales proceeds exceed the cost of the new purchase. For example, you elect to sell a portion of real estate for $10 million. However, you do not want to use all of those funds for your next investment. Perhaps you wish to use $1 million for another purpose. This $1 million is considered a boot and is subject to capital gains taxes in the tax year of the sale, under Section 1031 exchange rules.
The 1031 exchange rules also cover several smaller details, including the timing of changing the name on the title as well as how long you have to identify the transaction.