A 1031 exchange, also known as like-kind exchange, allows real estate investors to defer paying capital gains taxes on an investment property when it is sold, as long as another similar property is purchased with the profit gained by the sale.
Key points of 1031 exchange
- Eligibility:
- The property must be held for productive use in a trade or for investment purposes.
- The property exchanged must be of like-kind, meaning it must be of the same nature of character, even if it differs in character or quality.
- Types of Properties:
- Generally, real properties are considered like-kind to each other. For example, an apartment building can be exchanged for a commercial building, vacant land, or even a rental property.
- Generally, real properties are considered like-kind to each other. For example, an apartment building can be exchanged for a commercial building, vacant land, or even a rental property.
- Exclusions:
- Section 1031does not apply to exchanges of real property help primarily for sale, such as property held by a developer or a flipper.
- It also does not apply to certain exchanges involving tax-exempt use property subject to a lease.
- Deferred Exchanges:
- A deferred exchange allows the taxpayer to sell the property and then acquire the replacement property within a specific time frame.
- The taxpayer must identify the replacement property within 45 days of the sale and complete the exchange within 180 days.
- Reporting:
- The exchange must be reported on Form 8824, Like-Kind Exchanges, for the year of the exchange.
- Even if no gain or loss is recognized, the exchange must still be reported.
- Qualified Intermediary:
- A Qualified Intermediary (QI) is often used to facilitate the exchange. The QI holds the proceeds from the sale of the relinquished property and uses them to purchase the replacement property.
- A Qualified Intermediary (QI) is often used to facilitate the exchange. The QI holds the proceeds from the sale of the relinquished property and uses them to purchase the replacement property.
- Partial Exchanges:
- If the taxpayer receives money of other property (not like-kind) in addition to the like-kind property, they have a partially nontaxable trade. The taxpayer is taxed on any gain realized, but only up to the amount of the money and the fair market value of the other property received.
- If the taxpayer receives money of other property (not like-kind) in addition to the like-kind property, they have a partially nontaxable trade. The taxpayer is taxed on any gain realized, but only up to the amount of the money and the fair market value of the other property received.
Example of a 1031 Exchange Transaction
Scenario: John owns an investment property, a rental apartment building, with an adjusted basis of $200,000 and a fair market value (FMV) of $500,000. He wants to sell this property to purchase a commercial office building as a replacement property.
Steps in the 1031 Exchange:
- Sale of the Relinquished Property
- John sells his rental apartment building for $500,000.
- To defer the capital gains tax, John uses a qualified intermediary (QI) to handle the transaction. The QI holds the $500,000 proceeds from the sale.
- Identification of Replacement Property
- Within 45 days of the sale, John identifies a commercial office building worth $500,000 as the replacement property.
- Within 45 days of the sale, John identifies a commercial office building worth $500,000 as the replacement property.
- Purchase of the Replacement Property
- Within 180 days of the sale, the QI uses the $500,000 proceeds to purchase the commercial office building on John’s behalf.
- Within 180 days of the sale, the QI uses the $500,000 proceeds to purchase the commercial office building on John’s behalf.
- Basis Calculation
- The basis of the new commercial office building is the same as the adjusted basis of the relinquished rental apartment building, which is $200,000.
- If John had paid any additional money of received any non-like-kind property, adjustments would be made to the basis accordingly.
- Reporting the Exchange
- John reports the 1031 exchange on Form 8824, Like-Kind Exchanges, for the tax year in which the exchange occurred.
- He provided details of the relinquished property, the replacement property, and the qualified intermediary.
By using a 1031 exchange, John defers paying capital gains tax on the $300,000 gain ($500,000 fair market value – $200,000 adjusted basis) from the sale of the rental apartment building. Both the relinquished property (rental apartment building) and the replacement property (commercial office building) are considered like-kind as they are both held for investment purposes.
If there is any recognized gain due to receiving non-like-kind property or money, it is reported on Schedule D (Form 1040) or Form 4797, whichever applies.
