What is 1031 Exchange?
What is a 1031 Exchange?
A 1031 exchange is a legal process that allows real estate investors to defer the payment of capital gains taxes.
The process is also sometimes called, a ‘Tax-Deferred exchange’, a ‘Like-kind exchange’, or simply a ‘1031’. Regardless of the term used, a 1031 exchange originates from Section 1031 of the U.S. Internal Revenue Code.
This section of the Code allows investors to sell or relinquish an investment property, reinvest the proceeds in a replacement investment property of like-kind and greater or equal value, and defer the payment of any capital gains tax. To qualify for deferment of capital gains tax payment, the investor must follow the exact steps outlined in Section 1031, and the exchange must be done within specified time constraints.
Reasons for Doing a 1031 Exchange
The biggest advantage of using a 1031 exchange to sell one investment property and buy another is that the payment of capital gains tax is deferred.
Types of Property That Can Be Exchanged
There are two key property requirements for a 1031 tax-deferred exchange:
Both the property being sold, or sold, and the new Replacement Property must be ‘like-kind’. Real estate property that has been used in the taxpayer’s trade or business qualifies as like-kind property. A personal residence does not qualify as like-kind property because it isn’t held for business or trade purposes.
Some examples of like-kind property exchanges that meet the requirements of Section 1031 include:
- A single-family rental home, townhouse, or condominium for a larger multifamily property such as a duplex, triplex, or apartment building
- An office building or a shopping center, warehouse or industrial property, or a multifamily property, for another office building
- A hotel for a farm or ranch
- An apartment building for a hotel
- A residential rental property for a warehouse or distribution building
- A parking lot or garage for a marina
The IRS also requires that both the Sold Property and the Replacement Property must be held for investment or business purposes to qualify for tax-deferred treatment. An investor could not sell a primary personal residence to purchase an investment property and expect to receive tax-deferred treatment under Section 1031. By the same token, a 1031 exchange could not be used to relinquish an investment property and acquire a primary home.
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