A 1031 exchange in real estate is a swap between investment property and another, allowing capital gain taxes to go deferred. This term is derived from the Internal Revenue Service (IRS code Section 1031).

Real estate investors need to understand IRS Section 1031. For example, exchanges can only be done with like-kind properties. In addition, IRS rules restrict the use of vacation properties. Tax implications and time frames can also be problematic. If you are considering 1031 or just curious about them, here is what you need to know.

What Is Section 1031?

A 1031 exchange, also known as a similar-kind exchange and a Starker, is simply a swap of an investment property for another. Swaps are generally taxable as sales. However, if yours meets the requirements for 1031, there will be no or minimal tax.

You can modify the form of your investment without the IRS recognizing a capital loss. This allows your investment to grow tax-deferred. You can make 1031 as many times as you like. You can transfer the gains from one investment property to another. You don't pay tax until you cash out your swaps, even though you might make a profit. If everything goes according to plan, you will only pay one tax at a long-term capital gains rate (currently 15%-20% depending on your income, and 0% for those with lower incomes).

Most exchanges must be "like-kind, " an ambiguous phrase that can mean anything but what you think. An apartment building can be exchanged for raw land or a ranch to get a strip mall. These rules are surprisingly liberal. Even one business can be exchanged for another. There are many traps to avoid.

The 1031 provision can be used to invest and for business property. However, the rules may also apply to former primary residences if certain conditions are met. You can also use 1031 to swap vacation homes. But this loophole is now much smaller than it was.

Special Rules For Depreciable Property

When a depreciable property has to be exchanged, special rules apply. This can lead to a profit called depreciation capture, which is taxed at ordinary income. This recapture can be avoided if you swap a building for another. However, if you swap unimproved land for improved land with a structure, you will get the depreciation that you have previously claimed on the building as ordinary income.

These complications are why professional help is needed when you do 1031.

Modifications To The 1031 Rules

Some exchanges of personal property, such as aircraft and franchise licenses, were not eligible for a 1031 exchange before the passage of the Tax Cuts and Jobs Act in December 2017. Only real property (or realty) as defined by Section 1031 is eligible.

This change in tax law may be offset by the TCJA full expensing allowance of certain tangible personal property.

A transition rule in the TCJA allows for a 1031 exchange or replacement of qualified personal property in 2018. 1 This transition rule applies to the taxpayer only and does not allow for a reverse 1031 exchange if the new property was bought before the old property is sold.

Timing Rules And Delayed Exchanges

An exchange is a swap between two property owners. The chances of finding the right property for you are slim. The majority of exchanges are three-party or Starker exchanges, named after the first tax case that permitted them.

A qualified intermediary (middleman), who holds the cash and then purchases the replacement property, is required for a delayed exchange. This exchange is referred to as a swap.

Two key timing rules must be observed in a delayed trade.

45-Day Rule

The second refers to the designation of a replacement. The cash will be paid to the intermediary once your property is sold. The cash cannot be given to you, as it could spoil your 1031 treatment. You must also notify the intermediary within 45 days of selling your property.

You can designate up to three properties as long as one property is sold. If they meet certain valuation criteria, you can designate up to three additional properties.

Rule of 180 Days

Closing is the second rule for a delayed exchange. Close on the new property within 180 calendar days after the sale of your old property.

Tax Implications: Debt and cash

After the intermediary purchases the replacement property, you may still have cash. The intermediary will pay you the cash at the end of the 180 days if it is so. This cash, also known as "boot," will be subject to taxation as part of the proceeds from the sale or lease of your property. It is generally considered a capital gain.

Failing to take out loans is one of the most common ways people fall prey to these transactions. It is important to consider the mortgage loans and other debts on the property you are renouncing and any debts on the replacement property. You will receive income if you don't get cash back. However, your liability decreases.

Imagine that you have a $1 million mortgage on your old property. However, the mortgage you get on the new property is only $900,000. The $100,000 gain is "boot" and will be taxed.

1031s for Vacation Homes

There have been stories of taxpayers using the 1031 provision to exchange a vacation home for another. This could even be for a house they plan to retire from. Section 1031 delayed recognition of gains. They later moved into the new property and made it their primary residence. Later they planned to use the $500,000 capital gain exclusion. You can sell your primary residence, and you, along with your spouse, can shield $500,000 capital gain as long as you have lived there for at least two years.

This loophole was closed by Congress in 2004. So yes, taxpayers still have the option to turn vacation homes into rental properties or do 1031 exchanges. Ex: Your beach house is rented out for six months to a year, and then you can exchange it for another property. If you find a tenant and act professionally, you have likely converted your house into an investment property. This should allow you to complete your 1031 exchange.

According to the IRS, the IRS states that if the vacation property is offered for rent but does not have tenants, it would be disqualified from a 1031 exchange.

Move into a 1031 Swap Home

You can't immediately move into the property you have swapped to become your second or primary residence. The IRS established a safe harbor rule in 2008 that said it would not contest whether a replacement dwelling qualifies as investment property under Section 1031. In each of the 12-month periods immediately following the exchange, the safe harbor was met.

• For fair rental of the dwelling unit for more than 14 days, you must rent it to someone else.

• You cannot use the dwelling unit for your purposes for more than 14 days or 10% during the 12-month rental period.

You can't convert a vacation home or investment property into your primary residence immediately after swapping it.

An investor could transfer one rental property to another in a 1031 exchange, then rent the new property out for a while, then move in the property for a few more years, and then sell the property.

If you purchase property in a 1031 similar-kind exchange and then attempt to sell it as your principal residence within five years, the exclusion won't apply. Unfortunately, this means that you will have to wait longer to take advantage of the primary-residence capital gain tax break.

The Summary

Smart real estate investors can use a 1031 exchange to help build wealth and avoid taxes. However, these complex parts require understanding the rules and seeking professional help, even for seasoned investors.