A Comprehensive Guide to 1031 Exchanges

An interior of a home at Prescott Ranch, The owners benefitted from a 1031 exhange.

Are you interested in reinvesting your capital gains tax instead of paying it out? A 1031 exchange may work for you.

Put simply, a 1031 tax exchange allows for the investor to defer capital gains tax, which then results in more capital to invest in a substitution property. Normally, when an investor sells a property they must pay a portion of the sale in capital gains – both federal and state taxes. A 1031 exchange allows the investor to waive capital gains (for now) and instead invest in a replacement property.

Not only does this let real estate investors defer capital gains tax while buying and selling property, it also gives them access to exciting new investment strategies.

The IRS code dictates that the exchange must be done with “like-kind” properties, there are strict timelines to adhere to, and there must be a qualified intermediary involved in the transaction.

Investors looking for homes in Montana to lease out will find a number of attractive, newly built homes in the Belgrade area that will qualify as replacement properties to take financial advantage of the 1031 exchange

Why is it Called a 1031 Exchange?

Within Section 1031 of the IRS Code, you’ll find the essentials necessary for a successful property exchange. This exchange is recognized by the IRS as a means of deferring capital gain taxes.

Properties Eligible for 1031 Exchange

Not every property is eligible for this type of exchange; however, a number of properties are which means investors have more purchasing power than they may realize.

  • Single-family rental homes
  • Multifamily rental homes
  • Motels & hotels
  • Raw land
  • Offices & commercial properties
  • Farms & Ranches
  • Leasehold interests of 30+ years
  • Rental ski condo for a 3-unit apartment building

There are other eligible properties and to get more information, contact your tax advisor if you are interested in this type of exchange.

What Exactly Is a “Like Kind” Property?

Although this term is not specifically defined in the IRS tax code, professionals do have a definition for it. Any kind of real property that is held for productive use as in an investment, business, or trade may be considered like-kind property.

The kinds of property that can be exchanged in a 1031 transaction are very broad. For example, a single-family rental property may be exchanged for a duplex (or more), a shopping center, raw land, or even an office for apartments.

Any property that’s been relinquished that was held in investment will be in like kind with property with the intent to be held in investment.

Properties Not Eligible for 1031 Exchange

The main idea behind what might be eligible for a 1031 exchange and what isn’t, is the intent to which you purchased the property, and your intent for the exchanged property. Both sides of the equation must be that they are held in investment, so personal residences and partnership interests do not apply.

  • Real estate investment trusts (REITs)
  • Stocks, notes, or bonds
  • Personal residences
  • Flips for resale (though there is a possible way around this – if you flip and then rent for a period of time, it may be eligible after a certain time period, likely a year, for the 1031 exchange, check with your tax advisor).
  • New Construction

Tax Benefits with a 1031 Exchange

Reset Depreciation

The IRS allows owners of real estate to depreciate their assets. After 27.5 years, investments may be depreciated due to deteriorating conditions over time. After reinvestment is made into a new property, the depreciation schedule is reset.

Fewer Taxes

Investors can reduce the taxes they pay by exchanging property in a state that imposes income taxes with an investment opportunity in a state that does not have an income tax. Some states that do not have income tax include Nevada, Texas, Florida, Wyoming, and Alaska.

Deferred Capital Gains

This benefit is one of the primary reasons investors make a 1031 exchange. It allows the deferring of the capital gains tax upon the selling of a property until they cash out. There are no limits on how often this can be done, and for many investors, it’s a lucrative way to continually leverage their financial position.

Important 1031 Exchange Vocabulary

Relinquished Property refers to the property that the investor will be selling. It must be an investment or business property and not a vacation home or primary residence.

Replacement Property refers to the property that is to replace the relinquished property. It must be of equal or greater value and “like kind” to the relinquished property.

A qualified Intermediary refers to the person or the company that holds the real estate sale proceeds and subsequently facilitates the exchange. This person or company holds the exchange funds because IRS tax law dictates the seller of the property cannot or the funds will be subject to tax liability. The qualified intermediary can’t have any other formal relationship with the seller and must be a licensed professional. Overall, a 1031 exchange lets the investor reinvest the money that would normally be paid out to capital gains tax and put it into a replacement property.