What is a 1031 Exchange?

In the world of real estate, a 1031 Exchange is not an uncommon ordeal, but still many do not know what it is exactly. The term “1031” comes from the Internal Revenue Code (IRC) 1031 (26 U.S.C. § 1031) which allows for the deferral of capital gains when buying and selling like kinds of property. What this means is when one person sells a type of property (e.g. apartment complex) and then buys a similar piece of property (e.g. hotel building), the payment of taxes on the gain from the sale of the first property is delayed. The catch is that the second property must be of equal or greater price than the first. Also, both pieces of real estate, the one bought and the one sold, must be held for reasons of investment, production of income or for use in one’s business; residential real estate is non-applicable.

The primary reason many investors decide to go along with a 1031 Exchange is to not get stuck with a large tax bill; the only objective of the investor is to upgrade the real estate while simultaneously not paying all of the profits from the sale immediately. A general example is an expanding business who sells their current office building to move into a larger office that accommodates their growth. As long as the second office is of the same value or greater, the building owner can delay tax payments on any gains from the sale of the old building by following the rules of the 1031 Exchange.

There are other requirements of the 1031 Exchange as well, including a 45-day and a 180-day time limit (could be shorter depending on the tax return due date) and the use of a Qualified Intermediary to hold profits from the sale.  Within 45 days of the sale of the first property, the owner must identify all properties that he/she has intentions to buy in writing and sign the document.  That document must either be given to the sellers of the new property or the Qualified Intermediary (within that 45-day period); if a third party is given the document (e.g. the investor’s attorney or real estate agent), the 1031 Exchange becomes void and the capital gains from the sale of the first property sale are immediately available for taxation.

The second property must be purchased within 180 days of closing the first (including extensions) or by the tax return due date for the period that covers the sale of the property, whichever is earlier. Extensions aren’t available for either time limit and missing any of the timeframes specified results in the 1031 Exchange becoming void.

In the end, a 1031 Exchange is an effective way to trade real estate without getting hit with capital gains taxes.

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