What is a 1031 exchange?

Dated: February 5 2021

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I just helped a client complete a 1031 exchange and thought it would be helpful to explain a little bit more about the process.  As always, I am not a financial advisor, so please seek financial guidance if you are interested in further details.

In real estate, a 1031 exchange is a swap of one investment property for another that allows capital gains taxes to be deferred. The term, which gets its name from IRS code Section 1031.  IRS Section 1031 has many moving parts that real estate investors must understand before attempting its use. An exchange can only be made with like-kind properties and IRS rules limit use with vacation properties. There are also tax implications and time frames that may be problematic. Still, if you're considering a 1031—or are just curious—here is what you should know about the rules.

The majority of exchanges are delayed, three-party, or Starker exchanges (named for the first tax case that allowed them).

In a delayed exchange, you need a qualified intermediary (middleman) who holds the cash after you "sell" your property and uses it to "buy" the replacement property for you. This three-party exchange is treated as a swap.

There are two key timing rules you must observe in a delayed exchange:

45-Day Rule

The first relates to the designation of a replacement property. Once the sale of your property occurs, the intermediary will receive the cash. You can't receive the cash, or it will spoil the 1031 treatment. Also, within 45 days of the sale of your property, you must designate the replacement property in writing to the intermediary, specifying the property you want to acquire. The IRS says you can designate three properties so long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.

180-Day Rule

The second timing rule in a delayed exchange relates to closing. You must close on the new property within 180 days of the sale of the old.

You may have cash left over after the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash—known as "boot"—will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain.

Important Note: 

The two time periods run concurrently, which means you start counting when the sale of your property closes. If you designate a replacement property exactly 45 days later, for example, you'll have just 135 days left to close on it.

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Jeanine Best

Jeanine is a Chicago native and a 7 year resident of Peachtree Corners, GA. Jeanine and her family moved to Peachtree Corners in 2013 for her promotion with an Animal Health Pharmaceutical Company in....

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