How can you defer capital gains using a 1031 exchange?

1 What is a 1031 exchange?

A 1031 exchange, also known as a like-kind exchange, is a tax-deferred transaction that allows you to swap one investment property for another without paying capital gains tax on the difference in value. The name comes from Section 1031 of the Internal Revenue Code, which provides the legal basis for this strategy. The idea is that you are not selling your property, but exchanging it for another one of similar nature and use. Therefore, you are not realizing any gain or loss, but merely changing the form of your investment.

2 How does a 1031 exchange work?

To do a 1031 exchange, you need to follow a specific process and timeline. First, you need to identify a potential replacement property within 45 days of closing the sale of your relinquished property. You can choose up to three properties, as long as their total value does not exceed 200% of the value of your sold property. Alternatively, you can choose more than three properties, as long as their total value does not exceed 95% of the value of your sold property. Second, you need to close the purchase of the replacement property within 180 days of closing the sale of your relinquished property, or by the due date of your tax return for the year of the sale, whichever is earlier. Third, you need to use a qualified intermediary, also known as an exchange facilitator, to hold the proceeds from the sale of your relinquished property and transfer them to the seller of the replacement property. You cannot touch or control the money during the exchange period, or you will lose the tax-deferred status. Fourth, you need to ensure that the replacement property is of equal or greater value, equity, and debt than the relinquished property, or you will have to pay tax on the difference, known as boot.

3 What are the benefits of a 1031 exchange?

The main benefit of a 1031 exchange is that you can defer paying capital gains tax on the sale of your investment property, which can be as high as 20% at the federal level, plus state and local taxes. This means that you can keep more of your money working for you in a new property, and potentially grow your wealth faster. Another benefit of a 1031 exchange is that you can diversify your portfolio, change locations, upgrade to a better property, or consolidate multiple properties into one, depending on your goals and preferences. A 1031 exchange can also help you avoid depreciation recapture, which is the tax you have to pay on the portion of your gain that results from claiming depreciation deductions on your property.

4 What are the drawbacks of a 1031 exchange?

A 1031 exchange is not a free pass to avoid taxes forever. You will still have to pay capital gains tax when you eventually sell your replacement property, unless you do another 1031 exchange or use another tax strategy. Moreover, a 1031 exchange can be complex and time-consuming, and it requires careful planning and documentation. You have to comply with the strict rules and deadlines, and work with a qualified intermediary who will charge you a fee. You also have to find a suitable replacement property that meets your criteria and is available within the exchange period. Additionally, a 1031 exchange may limit your flexibility and liquidity, as you cannot cash out your equity or use it for other purposes without triggering tax consequences.

5 What are the rules and requirements for a 1031 exchange?

In order to qualify for a 1031 exchange, certain rules and requirements must be met. The properties involved must be held for investment or business purposes, not personal use or resale. Additionally, they must be of like-kind, meaning the same nature and character regardless of quality or grade. For example, an apartment building can be exchanged for a farm, but not a car or stock. Moreover, the properties must be located in the United States unless it is a foreign exchange with different rules and restrictions. Furthermore, they must be exchanged for each other and not sold and bought separately. Any cash or other property that is not of like-kind will require tax payments. Lastly, they must be identified and exchanged within the specified time frames of 45 days and 180 days respectively, and reported to the IRS on Form 8824 with your tax return for the year of the exchange.

6 Here’s what else to consider

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