1031 Exchange: What Real Estate Investors Need to Know

You might have heard about “Section 1031” in the news, as lawmakers have recently been talking about making changes to the tax code. What is a 1031?

When people in the media talk about a 1031 exchange, they’re actually talking about section 1031 of the Internal Revenue Code (IRC), our federal tax law. More specifically, a 1031 exchange is when one swaps one business asset for a different one. In the world of real estate, this translates into a property exchange.

Here’s what you need to know about Section 1031:

• Owners can postpone paying a capital gains tax by swapping property with another that is similar in nature.
• Property exchanges can also be used as a means of environmental protection by preventing future development in environmentally sensitive areas.
• Property bought for the purpose of flipping does not qualify for tax deferral under section 1031.

Additionally, there are some rules that must be followed in order to qualify for a 1031 exchange.

1. It’s not for homeowners

A 1031 exchange only benefits investors. Homeowners and people buying property with the intention of residing in it don’t qualify for the 1031 exchange.

2. Value restrictions apply

The only way for an investor to benefit from a 1031 exchange is if they purchase a property that is of equal or greater value than the one they intend to sell.

3. There are time constraints involved

When performing a 1031 exchange, the money you’ve made from your original property will be held by a third party until you close on the new property or properties. From the moment you’ve sold your original property, you’re given 45 days to find and identify a new property or properties that you intend to purchase. From then, you have 180 days to close on any new properties.

4. You can identify three properties

You’re able to choose up to three properties that you want to purchase. The reason that many investors choose more than one property is to protect themselves in case a deal falls through. As long as one of the three properties is successfully purchased, you’re still able to benefit from a 1031 exchange.

However, there is some flexibility with the three-property rule:

• Investors are able to identify more than three properties as long as the combined value doesn’t exceed 200% of the original property’s value.
• Alternately, you can identify any number of properties as long as you actually buy at least 95% worth of the aggregate value of all the combined properties.

Important Information Regarding 1031

Congress has been toying with the idea of eliminating or majorly restricting Section 1031. Doing so will have a number of tax implications for people planning on using tax-deferred exchanges, and could seriously impact smaller investors who owned the majority of the 15.7 million rental homes as of 2015.

If you’ve been planning to do a Section 1031 exchange on your property, it’s important that you are up-to-date on the news regarding the proposed legislation. You don’t want to be surprised by a large bill from the IRS because you’re no longer covered under the policy.  And as always, when considering an investment, consult your tax professional.