A 1031 exchange is a strategy in the U.S. real estate industry used to defer paying capital gains taxes when selling a property. It gets its name from Section 1031 of the U.S. Internal Revenue Code.
The “exchange” in 1031 exchange refers to the swap of one investment property for another. Under this provision, investment property owners can sell their property and then reinvest the proceeds in a new property, “exchanging” one property for another.
The basic rules are as follows:
- The property being sold and the property being acquired must both be considered “like-kind” properties. The term “like-kind” is broad, but the properties must both be of the same nature or character, even if they differ in grade or quality.
- The proceeds from the sale must go through the hands of a qualified intermediary and not through the seller’s hands. If the money goes directly to the seller, it can be taxable.
- There are timing restrictions. The seller has 45 days from the date of the sale of the old property to identify potential replacement properties. The transaction for the new property then needs to be closed within 180 days of the original sale.
- The new property must be of equal or greater value. Otherwise, the seller may be liable for tax on the difference in value.
By adhering to these rules, sellers can defer capital gains taxes, allowing more capital to be used towards investment in the new property. This process can be repeated any number of times, essentially allowing an investor to grow their real estate portfolio by continually deferring taxes. However, when a property is finally sold and not replaced, the deferred taxes must then be paid.