We took all 1031 exchange questions we have been asked since the beginning of the year and answered them in one convenient place. Can’t find what you need? Contact one of our 1031 specialists for a free consultation.
What is a 1031 Exchange?
A 1031 exchange derives its name from IRS section 1031. Section 1031 allows taxpayers to perform a tax-deferred exchange of either business or personal assets for “like” assets, meaning like-kind, or two real estate assets of a similar nature regardless of grade or quality. A 1031 exchange is relinquishing one investment property to acquire one or more other investment properties.
How Does a 1031 Exchange work?
In a 1031 exchange, one or multiple assets are exchanged for others of similar value.
For example, if you are interested in selling business property, a 1031 exchange might be an attractive option. It allows you to avoid the capital gains tax and use the proceeds from a sale to invest in another property of equal or greater value.
After the sale, a qualified intermediary (QI) will be entrusted with the proceeds. This is what protects the seller from tax liabilities. In most cases, the qualified intermediary can hold the monies for 45 days. Because of this, it may be required to present a list of three possible options to the QI for where you will reinvest.
The QI also acts as a middleman between the seller and the new property. A 1031 exchange is not simply trading one property for another but rather a non-simultaneous exchange of like-kind properties.
The tax advantages provide a great solution for individuals of all backgrounds looking to reinvest and/or grow their wealth.
Is there a Holding Period for a 1031 Exchange?
Currently, there is no specific holding period required for either property in a 1031 exchange outlined by the IRS. The IRS does stipulate the requirements for investment:
- The property must be held for productive use in a trade or business.
- The longer the property is owned, the easier it will be to prove that is the case.
- You want to avoid the appearance of flipping properties for profit which is not in line with the purpose or benefits of a 1031 exchange.
What is the Main Purpose of a 1031 Exchange?
The purpose of a 1031 exchange is to give property investors a way to sell one property and buy another of similar nature and value, with no immediate tax consequences as a result. The purpose of a 1031 exchange is for real estate reinvestment.
Can an LLC do a 1031 Exchange?
A 1031 exchange is done when one entity relinquishes a property for reinvestment elsewhere. An LLC does a 1031 at the entity level, but the entire partnership must agree and stay together to reinvest in the subsequent properties.
Can You Live in a 1031 Exchange Property?
The purpose of a 1031 is for reinvestment. With that in mind, if you end up living in property acquired through a 1031 exchange, you must remain living there for 5 years before taking further action.
Can You do a 1031 Exchange on a Primary Residence?
A primary residence that has been converted into a rental property will qualify for a 1031 exchange under IRS guidelines. It is best to plan if you want to follow this path, as you must show proof of rental for years before qualifying for the tax advantages of 1031.
How to Calculate a New Basis in 1031 Exchange?
- Begin with the adjusted basis of the property you are selling.
- Calculate the mortgage of the new property, any cash you will use, the amount gained on the sold property, and the value of other properties (if any) included in the exchange. Add this amount to the amount of #1
- Subtract any loss recognized from the sale property, any money received in the exchange, and the mortgage amount on the sold property.
The resulting sum will be the value of your new basis in the 1031 exchange.
What is a Reverse 1031 Exchange?
A reverse 1031 is when a buyer first purchases a replacement property and later sells the original property.
Is it Possible to Use a 1031 Exchange to Buy Airbnb Properties?
Yes, a 1031 exchange can be used to buy properties intended for use as Airbnbs. As long as the property is held long enough for investment or business use. In fact, the IRS came out with safe-harbor that directly addresses these types of property.
Read More: Complete Guide to Airbnb Investing
How Many Times Can You 1031 Exchange?
There is no limit to the number of times you can perform a 1031 exchange. Working with a qualified intermediary will help establish investment intent and allow for efficient exchanges every time.
What are the Rules for a 1031 Exchange?
The main rules to keep in mind when executing a 1031 exchange are the 45-day window to identify replacement properties and the 180-day limit to close on the replacement property or properties.
How do I Get Started in a 1031 Exchange?
Calling your Exchange Facilitator is the first step. Bring as much information as possible about the parties to the transaction. Also, have information about both the property being relinquished and those for proposed replacement. The more information provided initially, the more the process will be smooth and efficient with your Exchange Facilitator and 1031 exchange.
How Do I Choose a Facilitator?
Contact an exchange facilitation company. Your facilitator should have one function only and not also serve as agents, real estate agents, or escrow companies. Find someone capable of handling your situation and any problems that may arise.
What are the Time Requirements for a 1031 Exchange?
There are two-time requirements to consider with a 1031 exchange.
- From closing on the relinquished property, the investor has 45 days to propose a potential replacement.
- The replacement property must be proposed before midnight of the 45th day, with closing completed by the 180th day.
It is common to nominate three properties by the 45th day and acquire one or more of the three properties proposed.
What Restraints Do I Face When Identifying My Replacement Property(ies)?
The Exchangor must provide an “unambiguous description” of the potential replacement properties. A legal description or common address is enough to satisfy the IRS.
If you want to acquire multiple properties, you must do one of the following:
- Identify up to three properties with the intent of purchasing at least one.
- Identify more than three whose aggregate value does not exceed 200% of the relinquished property.
- Identify more than three with an aggregate value over 200% of the relinquished property allowing for 95% of the market value of all properties identified to be acquired.
What Closing Costs Can be Paid with Exchange Funds and What Cannot?
Closing costs can only be paid out of exchanged funds if the IRS considers them a Normal Transactional Cost. Work with your facilitator to determine the best option for your specific situation.
Is it OK to Go Down in Value and Reduce My Debt on the Property?
You may make an exchange and take some money out to use in other ways. That difference (boot) will be subject to capital gains tax.
What is a 1031 Exchange in California?
California allows for 1031 exchanges with a few additional state requirements. Any QI who holds funds and facilitates an exchange must be bonded for one million dollars or more. California also requires you to report a like-kind exchange if you both perform an exchange of property in California for property located outside the state and defer any gain or loss under IRC 1031.
You will also be required to continue to file FTB 3840 every year following:
- As long as you defer the gain or loss.
- Until you die.
- Until you report and pay the tax to California for any previously deferred gain or loss.
- If you do another 1031 exchange on the second property for another out-of-state property.
California also has what is called the California Clawback Law. This states that any capital gains acquired through CA real estate are subject to state tax upon its ultimate sale, even if the owner uses a 1031 exchange to acquire property outside the state.
If you are in California and considering a 1031 exchange, ensure that your Exchange Agent is familiar with the laws specific to the state.
What is a 1031 Exchange in Florida?
A 1031 exchange works the same as outlined above with a few extra wrinkles. Florida allows for reverse exchanges and both simultaneous and construction or improvement exchanges.
A simultaneous exchange is exactly what it sounds like; the closing of both sales happens simultaneously. However, any delay or complication could result in paying the full tax required.
An improvement or construction exchange is another option that allows you to use proceeds from the sale of the first property to make improvements on the replacement property. There are additional requirements with this type of 1031, and it is important to communicate your intentions with your qualified intermediary (QI) before beginning.
Read More: Florida 1031 Exchange Guide for Beginners
Does a Vacation Home Qualify for a 1031 Exchange?
You can use 1031 to purchase a vacation property, but you have to show intent to use the newly acquired property for investment purposes. Here are the details:
- You must rent the property out for a minimum of 14 days.
- You may only stay at the vacation home for 14 days or 10% of the rented days that year.
- Time spent for maintenance or construction does not count against the 14-day allowance.
How Much Does a 1031 Exchange Cost?
Working with a qualified QI for a typical 1031 exchange will cost around $1000.
Can You Do a Partial 1031 Exchange?
A partial 1031 exchange allows you to defer a portion of your capital gains and reinvest in a second property. The remaining profit will be subject to tax, but this is can be an attractive option that allows you to avoid heavier penalties.
Is the 1031 Exchange Going Away?
There have been proposed changes to the 1031 exchange. Most notably, limiting the amount available to be deferred to $500,000 for individuals or $1,000,000 for married couples. This has not been approved, and it is highly unlikely that 1031 exchanges will be eliminated or altered due to the adverse effects.
How Does a 1031 Exchange Affect the Buyer?
The biggest issues to be aware of as the buyer in 1031 are the time-sensitive deadlines already mentioned and the need to work with a trusted, Qualified Intermediary (QI).
How Does a 1031 Exchange Affect the Seller?
Largely, it will not affect the seller when the buyer is purchasing a property through 1031. As the seller, make sure you have included language in the contract freeing you from additional costs or liability because of 1031. The buyer may include a third party, the QI, with certain rights and responsibilities that you should also be aware of.