A “1031 exchange,” also known as a real estate exchange or a tax-deferred exchange, was created by the IRS in 1990.
A 1031 exchange is the sale of one investment for the purchase of another investment. In terms of real estate and/or mortgage, when a homeowner sells one investment property to buy another, like property, they can offset or even avoid capital gains tax.
In a 1031 exchange, the property sold is referred to as the “relinquished property” and the property acquired is called the “replacement property”.
Prior to the introduction of the 1031 exchange, a homeowner had to sell one property before the close of escrow on the new property, a practice which proved to be very difficult.
The IRS finally proposed a solution with the introduction of the 1031 exchange, which effectively allowed a homeowner to sell their relinquished property and use the proceeds to buy the replacement property later.
However, for the exchange to work, it must be overseen by a qualified intermediary and certain rules must be followed.
What type of property qualifies for a 1031 exchange?
Real estate is divided into four classifications, including property held for business use, land held for investment, property held for personal use, and property held primarily for sale. The first two qualify for a 1031 exchange, while the last two do not.
To completely offset capital gains, all proceeds from the relinquished property sale must be invested in the replacement property.
The properties exchanged must be of like-kind, meaning that they are of the same classification, and not based on their condition or quality. However, this category is broad, and can mean selling a farm to buy a house. Or selling a condo and buying a mini-mall.
Time Requirements of a 1031 Exchange
There are also certain time requirements that must be strictly followed. The identification period of the 1031 exchange begins the date the relinquished property is transferred (or deed recorded) and expires after 45 days.
In other words, you must identify a replacement property within 45 days of selling your old (relinquished) property and do so in writing to either the seller or the intermediary.
The exchange period begins on the date you transfer the relinquished property and ends after 180 days or earlier if tax returns for the taxable year in which the transfer occurred are submitted before those 180 days.
This means you get 180 days from the date of the sale of your old (relinquished) property to close on the replacement property.
Additionally, there must be an actual exchange overseen by a qualified intermediary, and not just a transfer of property for money only.
That being said, it’s always wise to seek the services of a professional early on to avoid any costly mistakes when executing a 1031 exchange.
Here are those rules again in a condensed list:
- the property exchanged must be of like-kind (pretty broad, e.g. exchange a commercial building for a rental condo or single-family rental home)
- the property must conduct business (e.g. investment property)
- the exchange must occur in the allotted time frames
- must use qualified intermediary or facilitator