The 1031 Exchange – Section 1031 of the U.S. Internal Revenue Code – allows investors to defer capital gains taxes on the exchange of like-kind properties. 1031, or tax-deferred, exchanges hold great advantages for both investors and realtors.

The Code reads: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like kind, which is to be held either for productive use in a trade or business or for investment.”

You may have heard real estate agents talk about how you can “1031” one property for another; and you might know that it has tax implications. Here are some basics to help you understand the code and to determine if the Exchange can benefit you.

Requirements for a 1031 Exchange

• Timelines for a 1031 Exchange: The investor, or exchanger, must follow the strict 45-/ 180-day guidelines for an exchange. Once the exchanger sells his property he has 45 days to identify property(s) of equal or greater value. Once identified, the exchanger has 180 days from the day he sold the property to acquire the property(s) identified (or 135 days from the end of the 45-day period).
• Like-Kind Property in a 1031 Exchange: The investor must acquire “like-kind” property. This means that it must be other qualifying forms of real estate. For example, the exchanger could sell a duplex and purchase a commercial property, or he could sell a piece of land and buy an apartment building. The property simply needs to be “like-kind.”
• Exchange Property Held for Investment: The property sold and the newly acquired property (replacement property) must be held for investment or business purposes. Therefore, you cannot sell your primary residence and buy an investment property, nor could you sell and investment property and purchase a primary home.
• Equal or Greater Debt and Equity in a 1031 Exchange: If the exchanger sells a property for $1 million, in which $500k was equity and $500k was debt, then the exchanger needs to purchase $1 million or more worth of property. Likewise, the exchanger needs to use all the equity and replace all of the debt to defer 100% of the capital gains taxes.
• Constructive Receipt and Qualified Intermediary for a 1031 Exchange: The exchanger may not receive cash from the sale. This is known as “constructive receipt” and would trigger a taxable event on those monies received. According to the IRS safe harbor provisions, the exchanger must use a Qualified Intermediary (QI) to facilitate the 1031 transaction. The QI is an independent 3rd party (not your attorney, agent, broker or CPA) who holds the sales proceeds and purchases the replacement property on your behalf. It is extremely important in today’s environment to associate only with reputable, insured and bonded qualified intermediaries.
• 1031 Exchange Risk: As with any investment in real estate, there are risks. As an investor you should thoroughly understand all risk factors and discuss them with your financial advisor or attorney before proceeding.