Do you want to trade your investment property for another with limited or no tax? Consider doing a 1031 exchange.
What’s a 1031 exchange?
A 1031 exchange, also called a Starker or like-kind exchange, is an arrangement where you swap one investment asset for another. Most swaps are taxable sales, but with a 1031, you can defer or limit capital gain taxes.
From the perspective of the Internal Revenue Service (IRS), there’s no cash out or capital gain, so you can change the form of your investment and let it grow continuously with tax deferred.
Like-kind property refers to any real property or real estate held for trade, business, or investment purposes.
Examples of swaps include:
Unimproved property in exchange for improved property
Vacant land in exchange for a commercial building
Duplex in exchange for retail property
Single family rental in exchange for a multi-family apartment
Industrial property in exchange for rental vacation property
1031 exchange rules
The name and tax return that appears on the property’s title should be the same as the tax return and titleholder making the purchase. In case of SMLLCs, or single-member limited liability companies, the company is considered a pass-through to the member, so the SMLLC can be the seller while the member can be the buyer in their own name.
After the first property’s closing, you have 45 days to disclose the addresses of possible replacement properties to the closing entity or the accommodator who facilitates a 1031 exchange.
In case of a reverse exchange in which the replacement property has been parked, you have to submit the finalized list of properties for purchase within 45 days.
In order to defer tax, the sold property’s equity and its net market value should either match or exceed that of the replacement property. If not, you’ll have to pay the difference between the two. Likewise, the replacement property’s equity and debt should also match or exceed the debt and equity on the corresponding relinquished property.
While additional equity on the replacement property can offset debt, keep in mind that additional debt, in reverse, won’t offset equity.
You must purchase the property within 180 days after the first property’s closing or the extension on your tax return.
Related party transactions
Related party transactions take place when you sell or buy property to or from a related party, such as a family member, grantor of a trust, a corporation in which you own at least half the stock value, or another member corporation within a controlled group.
If you’re selling to a related party, the property should be held for two years before selling or before the tax to be deferred by the exchange is due. You can only purchase replacement property from a related party if they also initiate an exchange.
Time is one factor that shows your intent to hold the property for investment. The IRS will try to determine if the property had been acquired soon before the 1031 exchange.
For instance, they’ll investigate if it was indeed purchased to be flipped, rented out, and kept for productive use, or if personal use of the property exceeds 14 overnights each year. Otherwise, it qualifies as a vacation home, not an investment property.
Knowing the basics of 1031 exchanges will help you maximize the potential benefits of a transaction.