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What Is a 1031 Exchange?

What Is a 1031 Exchange?

April 07, 2022

Do you own Investment or Business Properties? 1031 exchanges could be a powerful tax planning tool for you when it comes time to sell property.

What is a 1031 exchange?

A 1031 exchange (named for Section 1031 of the US Internal Revenue Code) is the exchange of one investment property for another that allows the owner to defer capital gains taxes. This can be done with “like-kind” properties, which is defined broadly – typically any investment or business property can be used; for example, an apartment building could be exchanged for raw land. When you sell a property, instead of receiving cash and paying the capital gains taxes, you can roll the gain into another real estate investment, and another, and another. Your profit on these properties might continue to grow throughout the exchanges, but you are able to avoid paying taxes on those gains until you sell for cash many years down the road. If the properties are never sold for cash and the owner passes away, the heirs will recognize a step-up in basis and are able to avoid the capital gains tax permanently. A “step-up in basis” means the cost basis of the asset is increased to the current value of the asset, which eliminates the taxable gains. As long as the rules are followed, there are no limits on the number of 1031 exchanges you can do.

How does a 1031 exchange work?

1031 exchanges are typically done on a delayed basis using a third party where there is a 180-day timeline to complete the exchange. When you sell your property, the proceeds must go to a “qualified intermediary” who works as the middleman to hold the cash until you are ready to buy the replacement property. Within 45 days, you must identify the replacement property you intend to purchase. The IRS allows you to designate three properties as long as you eventually choose to close on one of these properties. You must then close on the replacement property within 180 days of the sale of your original property. 

If you want to do a 1031 exchange, you must arrange it BEFORE the sale of the property so that the proceeds will go directly to the qualified intermediary.

What if I don't want to buy another physical property?

If you don’t want to purchase another property but still want to use a 1031 exchange to defer capital gains, you can invest in a “Delaware Statutory Trust,” or “DST.” DSTs allow fractional ownership of a single property or a portfolio of properties, and this investment qualifies as a replacement property in a 1031 exchange. By investing in a DST, the investor doesn’t need to worry about the management of the property – that is handled by the trustee. These investments typically last 3-10 years, and then another 1031 exchange could be used until you are ready to sell for cash and pay capital gains taxes, or can be continually used until death when the heirs will receive a step-up in basis.

Can I do a 1031 exchange on my vacation home?

Vacation homes typically do not qualify for 1031 exchanges unless they are rented out (thereby qualifying them as an investment property).

If you own investment properties and think a 1031 exchange might make sense for you, remember that the 1031 process needs to begin before the sale of the original property. Please reach out to us if you'd like to discuss how a 1031 exchange might fit into your financial plan.

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