The IRS 1031 Exchange document is a tax filing that enables real estate investors to forego capital gains tax on the sale of a property as long as they use their proceeds in qualified ways. Named for the section of the IRS code that provides for this strategy (IRC Section 1031), a 1031 Exchange is one of the most neglected and powerful ways to retain capital power in a real estate investment portfolio, giving investors in the commercial and rental real estate marketplace an advantage over traditional investment strategies that are typically subject to capital gains tax.
What Is a 1031 Exchange?
The IRS explains that a 1031 exchange “provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange.”
This IRS definition identifies two aspects of a 1031 exchange: (1) a qualified intermediary, and (2) a like-kind exchange.
In the case of a Standard 1031 Exchange (sell first, buy later), a qualified intermediary is an account holder who receives the profits of your relinquished property when it sells and depositing it in the acquired property’s account upon the purchase of the replacement property. In the case of a Reverse 1031 Exchange (buy first, sell later), the qualified intermediary holds the title to the purchased property until the relinquished property is sold and the funds can be dispersed according to the specifics of the exchange, having been sheltered from capital gains tax in both cases.
A like-kind exchange is one in which the relinquished property (the property being sold) and the acquired property (the property being purchased) are both “held for use in a trade or business investment.” Property used primarily for personal use, such as an owner’s residence, second home, or vacation home, do not qualify for like-kind exchanges.
What is the Timeframe of a 1031 Exchange?
There are two time limits involved in a 1031 Exchange.
The first limit is that the owner has 45 days from the date the property is relinquished to personally identify in a signed document identifying potential replacement properties.
The second time limit is that the replacement property (or relinquished property in the case of a reverse exchange) must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold (whichever is earlier).
What Properties Qualify for a 1031 Exchange?
Properties that do not qualify for a 1031 Exchange include:
- Inventory or stock in trade
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Certificates of trust
Read more about the specifics of the IRS policy on the 1031 Exchange here. You can find more information about how the IRS treats conditions such as abandonments, foreclosures, inheritances, and opportunity zones in their recently published handbook Sales and Other Dispositions of Assets: For Use in Preparing 2021 Returns.