What is a 1031 Exchange?

What is a 1031 Exchange?

A 1031 exchange lets you sell your investment property and then buy another one without paying taxes. To do this, you must make the same type of property, even if it is not of more excellent value, within a specific time limit.

A 1031 exchange is a complicated way to put your money into another investment property without paying taxes on the capital gains.

And while that might sound like bad news for Uncle Sam, there are several benefits for the government. By deferring taxes until later (and often at lower rates), you're able to invest more money now with less out-of-pocket expense - meaning your investments will have a much higher chance of growing.

What Does the IRS Say About 1031 Exchanges?

A 1031 exchange lets you sell a qualifying real property and use the proceeds to purchase a similar one in an area so that you reduce your net costs in the transaction.

The law allows you to roll over or defer tax payments when buying, selling, or investing in a piece of investment property by exchanging it for another "like-kind" asset of equal value.

Since this is just a postponement of payment, not elimination, investors cannot simply keep cash proceeds and buy real estate.

How to Qualify for a 1031 Property Exchange

To qualify as a 1031 Property Exchange:

1. You must sell real property such as a home, condo, or commercial building.

2. You need to acquire comparable new property within 45 days from the date you sold the previous property.

3. The exchange must be for "like-kind."

   Real estate is considered "like-kind" when it's exact and character (for example, a house and another house), like class (for example, land and farmland), or like grade (for example, residential and commercial real estate).

4. You need to hold onto your new investment property for at least six months after selling it.

5. Your total gain from the sale and purchase must equal each other, minus any closing fees.

   This way, neither party pays taxes on gains from depreciation or appreciation (if you leave out costs such as broker commissions, title work, and escrow fees).

How To Do A 1031 Exchange: An Example

Let's say that you decide to do a 1031 exchange. You want to sell your duplex with an adjusted basis of $180,000 and purchase a four-plex with an adjusted basis of $200,000. Your net gain is $20,000.

You're able to write off the part of your new investment that covers costs like closing fees or carrying costs (for example, interest and taxes).

With that in mind, to complete a 1031 exchange, you must reinvest all the funds you received from your old investment in your new one.

To defer paying tax on some of your capital gains, you need to stay within certain limits.

For example, investors looking to complete a 1031 exchange must purchase another residential property that doesn't exceed two units every 24 months or invest in nonresidential properties such as commercial buildings or land during any 12 months for up to $250,000 ($500,000 if married filing jointly).

What Are the Benefits of 1031 Exchanges?

So, why exactly do investors opt for a 1031 exchange rather than paying tax on every real estate investment? The main benefit of a 1031 exchange is moving funds into other assets that might be more beneficial tax-wise.

For example, if you own a property in an area with high taxes and want to invest in one similar but located somewhere else with lower taxes, you could complete a 1031 exchange.

Another possible benefit is that some investors sell their properties below market value, which allows them to accumulate enough money for future investment opportunities without paying the capital gains tax on the profit they make during the initial sale.

How to Report a Property Exchange on Your Taxes

When filing your taxes after completing a 1031 exchange, you need to report it as "other income" on Form 4797 (Capital Gains and Losses).

It would be best if you typically waited until you receive your 1099-B before including it on your tax return, but some types of exchanges, such as like-kind exchanges, get different treatment.

If you choose to do a reverse exchange instead of just an exchange, you need to report the transaction as "other income" on Schedule D (Capital Gains and Losses) instead.

Finally, make sure that any money you keep from the sale or trade-in during this process goes towards closing fees or related costs, not towards the purchase price of your new property.

You avoid paying capital gains tax while maintaining equal amounts of investment properties over time by putting money toward other property expenses.

1031 exchanges are a great way to avoid paying taxes on your investments without having to sell them. Investors complete a 1031 exchange by purchasing another property of the same or like-kind, with equal or more excellent value than the one you just sold.