1031 Exchange Rules: What You Need to Know
How savvy investors use 1031s to defer capital gains and build wealth
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, is bandied about by realtors, title companies, investors, and soccer moms. Some people even insist on making it into a verb, as in: "Let's 1031 that building for another."
- A 1031 exchange is a swap of properties that are held for business or investment purposes.
- The properties being exchanged must be considered like-kind in the eyes of the IRS for capital gains taxes to be deferred.
- If used correctly, there is no limit on how many times or how frequently you can do 1031 exchanges.
- The rules can apply to a former primary residence under very specific conditions.
What Is Section 1031?
Broadly stated, a 1031 exchange (also called a like-kind exchange or a Starker) is a swap of one investment property for another. Although most swaps are taxable as sales, if yours meets the requirements of 1031, you'll either have no tax or limited tax due at the time of the exchange.
Most exchanges must merely be of "like-kind"—an enigmatic phrase that doesn't mean what you think it means. You can exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another. But there are traps for the unwary.
Special Rules for Depreciable Property
Special rules apply when a depreciable property is exchanged. It can trigger a profit known as depreciation recapture that is taxed as ordinary income. In general, if you swap one building for another building you can avoid this recapture. But if you exchange improved land with a building for unimproved land without a building, the depreciation you've previously claimed on the building will be recaptured as ordinary income.
Changes to 1031 Rules
Before passage of the new Taxes Cuts and Jobs Act (TCJA). in December of 2017, some exchanges of personal property—such as franchise licenses, aircraft, and equipment—qualified for a 1031 exchange. Under the new law, only real estate qualifies.
The TCJA includes a transition rule that permitted a 1031 exchange of qualified personal property in 2018 if the original property was sold or the replacement property acquired by December 31, 2017. The transition rule is specific to the taxpayer and did not permit a reverse 1031 exchange where the new property was purchased before the old property is sold.
Delayed Exchanges and Timing Rules
Classically, an exchange involves a simple swap of one property for another between two people. But the odds of finding someone with the exact property you want who wants the exact property you have is slim. For that reason, the majority of exchanges are delayed, three-party, or Starker exchanges (named for the first tax case that allowed them).
There are two key timing rules you must observe in a delayed exchange:
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.
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.
Tax Implications: Cash and Debt
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.
1031s for Vacation Homes
You might have heard tales of taxpayers who used the 1031 provision to swap one vacation home for another, perhaps even for a house where they want to retire and Section 1031 delayed any recognition of gain. Later, they moved into the new property, made it their primary residence and eventually planned to use the $500,000 capital-gain exclusion. The exclusion allows you to sell your primary residence and, combined with your spouse, shield $500,000 in capital gain, so long as you've lived there for two years out of the past five.
Moving into a 1031 Swap Residence
If you want to use the property you swapped for as your new second or even primary home, you can't move in right away. In 2008 the IRS set forth a safe harbor rule, under which it said it would not challenge whether a replacement dwelling qualified as an investment property for purposes of Section 1031. To meet that safe harbor, in each of the two 12-month periods immediately after the exchange:
- You must rent the dwelling unit to another person for a fair rental for 14 days or more15
- Your own personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
The Bottom Line
A 1031 exchange can be used by savvy real estate investors as a tax-deferred strategy to build wealth. The many, complex moving parts not only require understanding the rules, but also enlisting professional help—even for seasoned investors.