Generally, profits earned on the sale of property are subject to capital gains tax. A common strategy for deferring capital gains is to complete a section 1031 exchange. The term “1031 exchange” refers to section 1031 of the Internal Revenue Code, which allows investors to defer paying capital gains taxes on an investment property following a sale. To defer capital gains, the investor must purchase, or roll into, another “like-kind” property with sale proceeds from the initial investment.
If you are considering utilizing a 1031 exchange in the sale of an investment property (the “relinquished property”) and purchase of another (the “replacement property”), there are important rules you must follow to ensure that the transaction is eligible. These include:
- Generally, the properties exchanged must be real estate, even if they differ in grade or quality. Before 2018, 1031 exchanges could involve assets like intellectual property and commercial car fleets. Under the Tax Cuts and Job Act of 2017, section 1031 now applies solely to the exchange of real property – not personal or intangible property.
- Investors must identify a potential replacement property within 45 days of the sale of the relinquished property. The transaction must be completed within 180 days of the purchase of the relinquished property.
- An investor can identify more than one replacement property, subject to the “three-property” and “200%” rules. The three-property rule allows an investor to identify a maximum of three potential replacement properties without regard to their fair market value. The 200% rule permits the investor to identify any number of replacement properties so long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of the relinquished property.
- Properties held for sale are not eligible for 1031 exchanges. A property that an investor intends to flip, for example, is not an eligible asset for a 1031 exchange. A primary residence is also generally ineligible because it is not considered to be a property held for investment.
- Investors can’t hold the money from the sale during the 180-day exchange period. Sale of the relinquished property must be coordinated through a qualified intermediary (“QI”). QIs are third-parties that facilitate 1031 exchanges. You cannot act as your QI. QIs also cannot be close family members or other “disqualified persons” such as an attorney, accountant, investment banker, or real estate broker who has acted as your agent during the prior two years.
These rules are just the basics. 1031 exchanges require significant planning and a high degree of coordination among the parties involved, but they can contribute greatly to the accumulation and preservation of wealth assets. 1031 exchanges also can be made into Delaware statutory trusts and tenant-in-common structures that can allow you to expand and diversify your real estate holdings.
Not an offer to buy nor a solicitation to sell securities. All investing involves risk, and past performance may not be indicative of future results. You should consult with your financial, tax, or other advisors to determine whether an investment is suitable for you.