A 1031 exchange is a swap of one investment property or parcel of land for another that allows capital gains taxes to be deferred.
The term gets its name from the IRS code Section 1031.
Before attempting to use Section 1031 for your benefit, you must understand the many moving parts involved.
For instance, an exchange can only be made with like-kind properties and IRS rules limit Section 1031 use with vacation properties.
In addition, there are tax implications and time frames that can be problematic.
In this blog, we’ll dive into the 1031 exchange process.
Let’s get started.
1. What is Section 1031?
Section 1031 is a provision in the United States Internal Revenue Code that allows business owners of investment property to defer federal taxes on some exchange of real estate.
It’s used by investors who are selling one property and reinvesting the proceeds in one or more other properties.
It’s not available to buyers or sellers of personal homes.
Qualified Section 1031 exchanges are called “1031 exchanges,” “like-kind exchanges,” or “starker exchanges.”
Sometimes, Section 1031 is referred to as the Starker Loophole.
This loophole has been attached to the law since a 1979 court ruling that concluded that an agreement to exchange real property (within certain time limits) is essentially the same as a simultaneous transfer of property.
Previously, this loophole was much more generously defined.
Prior to December 31, 2017, the like-kind property could be any broad range of real and tangible personal property that was held for business or investment purposes.
This included franchises, art, equipment, stock in trade, securities, partnership interests, certificates of trust, and beneficial interests.
After December 31, 2018, the only permissible property for 1031 exchanges is business or investment real estate.
2. What are the rules for using Section 1031?
Section 1031 allows you to defer capital gains tax on exchanges of like-kind real estate if it’s done in a timely manner.
However, there are rules for using Section 1031.
The real estate purchased with the proceeds must be like-kind.
The tax must be paid on any “boot” in the year of the 1031 exchange.
A boot is an addition of value to the swap that is not real estate.
Once the business or investment real estate is sold, like-kind real estate must be identified within 45 days and acquired within 180 days.
3. What is a like-kind property?
The term like-kind property refers to two real estate assets of a similar nature regardless of grade or quality that can be exchanged without incurring any tax liability.
The Internal Revenue Code (IRC) defines a like-kind property as any held for investment, trade, or business purposes under Section 1031.
This means that both properties involved in the exchange must be for business or investment purposes.
As a result, personal residences do not qualify as like-kind properties.
If people or businesses hold qualifying businesses or investment properties, they can exchange them in a like-kind exchange and avoid paying capital gains on the exchange.
In order for this to work, the like-kind property must meet the definition set out by the IRS to qualify for the Section 1031 transfer.
For tax deferral purposes, like-kind properties cannot be sold directly, but rather must be exchanged through a qualified intermediary.
4. What qualifies as like-kind property?
Not all property qualifies as like-kind.
The types of land and real estate that can be exchanged are extremely broad.
In fact, any real estate held for productive use in a trade or business or for investment (whether improved or unimproved) is considered “like-kind.”
Here’s a list of properties that would qualify as like-kind:
Hotels or motels
Tire and automotive stores
Delaware Statutory Trust (DST)
5. Is undeveloped land eligible for a 1013 exchange?
Yes, all forms of land, including undeveloped land, are eligible for a 1031 exchange.
However, if you plan to buy a vacant lot, develop it, and benefit from its sale after a tax-deferred exchange, then it is not eligible.
The IRS deems this as intent to sell (not investment or business purposes).
If you’re planning on doing a 1031 exchange with vacant land, prepare and plan ahead with your qualified intermediary.
6. Can I sell my agricultural land through a 1031 exchange?
If you’re anticipating that you’ll sell your farm, ranch, orchard, or any other kind of agricultural land, then a 1031 exchange is a great idea.
Agricultural land is typically eligible; however, there are few caveats.
- If your primary home is on the property, it is not eligible.
- Your personal property, including farm equipment, livestock and machinery cannot be included.
Still, a 1031 exchange can still help you avoid paying capital gains taxes on the sale of your farmland.
If you’ve owned your property for a long period of time, selling it can result in a huge tax liability upon the sale.
Don’t let years of hard work be wasted in paying unnecessary taxes!
7. What do you do with the proceeds from agricultural property?
When you do a 1031 exchange with land, it allows you to put all of your hard-earned proceeds to work.
Most sellers are looking to swap their agricultural land for that produces a monthly cash flow, but don’t know where to start.
Working with a 1031 exchange facilitator can help you understand the best way to use this money to your advantage.
Read more about finding a facilitator in #10.
8. Can a vacation home be sold through a 1031 exchange?
Under safe harbor regulations, a vacation home can qualify if it meets the following requirements:
The property was owned for 24 months
Within each of the prior two 12-month periods:
- The unit must be rented at fair market rental for at least 14 days
- You cannot have used the home for personal use for greater than 14 days or ten percent of the number of days that it was rented at fair market rental
9. What does not qualify for a 1031 exchange?
Property held “primarily for sale”.
For example, fixer-uppers or vacant land that will be developed into houses.
Property that involves stocks, bonds, notes, securities, and interests in a partnership (even if it is used in trade, business, or investment).
Primary residences because they’re not used in trade, businesses, or investments.
Even if a portion of a primary residence is involved in your trade or business, it may not qualify for a 1031 exchange.
10. How do I get started in a 1031 exchange?
To get started in a 1031 exchange, call your Exchange Facilitator.
It will likely be helpful for you to have information regarding the parties to the transaction at hand (names, addresses, phone numbers, file numbers, etc.).
During the call, your Exchange Facilitator will ask questions regarding the property being relinquished and any proposed replacement property.
Keep in mind that the initial conversation will vary from company to company.
Some companies will require more information to get started while others will only require basic information.
That said, it’s helpful to go into a conversation with at least the information listed above.
11. How should I choose a 1031 exchange facilitator?
To choose a 1031 facilitator, contact an exchange facilitation company.
Often, the best place to get the names of facilitators is from attorneys, CPAs, escrow companies, or real estate agents.
That said, you can also just search local exchange facilitation companies on the internet to see which have the best reviews.
Keep in mind that facilitators should not be acting as “agents” in addition to facilitators.
Escrow companies, attorneys, real estate agents, etc. are agents and should not be used as facilitators as well.
When hiring an exchange facilitator, ask questions about the procedures they use and the assistance they can provide if problems arise.
Price is important, but it shouldn’t ultimately make the decision for you.
Exchange fees typically range between $400 and $750.
The difference in price often reflects a difference in service.
You may also wish to obtain copies of the documents the facilitator will use to be reviewed by your attorney.
12. How long will a 1031 exchange take?
The investor has 45 days to nominate potential replacement properties from the time of closing on the relinquished property.
Then, there’s a total of 180 days from closing to acquire the replacement property.
There are also some identification requirements involved.
The investor must identify the replacement property prior to midnight on the 45th day.
The investor typically nominates three potential properties of any value and then acquires one or more of the three within 180 days.
Typically, a common address or an unambiguous description will suffice.
If the investor needs to identify more than three properties, then they should consult with their 1031 facilitator.
13. Can you do a 1031 exchange if you have a mortgage?
Yes, a 1031 exchange isn’t just about the purchase price of your replacement property.
Your “old” property can have a mortgage.
If this is the case, however, then there’s a financing requirement that you’ll have to meet on the replacement property as well.
In short, 1031 exchanges require a certain purchase price and debt structure.
There are two main rules you’ll need to follow when it comes to the financial requirements:
The purchase price of the property or properties that you buy must be equal to or exceed the sales price of the property or properties that you sell.
Ex: If you sell a property for $500,000, then you’ll need to buy another property for at least that amount.
There’s a debt-financing requirement that applies if you have a mortgage on your original property.
You’re required to carry as much debt or more with your replacement property.
14. Is there anything else I should know?
To make sure you have all the basics, here are seven simple points that you should have a clear understanding of before moving forward with a 1031 land exchange.
This is a commonly misunderstood concept in 1031 exchanges.
Like-kind relates to the use of properties.
The old property and the new property must both be held for investment or utilized in trade or business.
45-day identification period
The IRC requires that the new property be identified within 45 days of closing the sale of the old property.
The 45 days commence the day after closing and are calendar days.
180-day purchase period
Section 1031 requires that the purchase and closing of one or more of the new properties occur by the 180th day of the closing of the old property.
The generally accepted time period you will need to have owned the property prior to the exchange.
Use of a qualified intermediary
Sellers are not permitted to touch the money in between the sale of their old property and the purchase of their new property.
By law, the taxpayer must use an independent third party known as an exchange facilitator to handle the exchange.
The individual who serves in this role cannot be someone with whom the taxpayer has had a family relationship or alternatively a business relationship during the past two years.
Title must be mirror image
Section 1031 requires the taxpayer listed on the old property to be the same taxpayer listed on the new property.
Whether it’s an individual, couple, trust, or corporation, the same must be listed on the title to the new property as was listed on the old title.
Reinvest equal or greater amount
To defer 100% of the tax on the gain of the sale of old property, the new property must be of equal or greater value.
Two requirements are involved with this rule.
1) The new property has to be of greater or equal value to the old which is sold
2) All of the cash profits must be reinvested
In reverse exchanges, title to both properties cannot be in the same name at the same time.
With reverse exchanges, all previous requirements are applicable and then there are some additional requirements.
A reverse exchange may occur when a seller does not yet have a buyer for the property that he wishes to sell.
He may be afraid of losing the property that he wishes to acquire.
That said, a taxpayer may not have both the old and the new property titled in their name at the same time and qualify for a reverse exchange.
A 1031 exchange occurs when an investor uses funds obtained through the sale of land is used to purchase new land.
That said, there are rules and regulations that dictate the terms under which land can be sold.
Knowing these can ensure that you qualify for the tax deferral.
Additional ResourcesIf you are looking to buy affordable land, you can check out our Listings page. And before you buy land, make sure you check out Gokce Land Due Diligence Program. If you are looking to sell land, visit our page on how to Sell Your Land.
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Disclaimer: we are not lawyers, accountants or financial advisors and the information in this article is for informational purposes only. This article is based on our own research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.