1031 Exchange Rules 2023: A Comprehensive Guide

A 1031 exchange is a powerful tool for real estate investors, allowing them to sell a property and reinvest the proceeds in a new one without paying capital gains tax.

To qualify for a 1031 exchange, the property sold must be a "like-kind" property, which means it must be of the same nature or character as the original property.

The IRS defines "like-kind" as any property that is held for investment or used in a trade or business. This includes real estate, rental properties, and even some types of personal property.

The exchange must be done through a qualified intermediary, who will hold the funds and ensure that the exchange is done properly.

A 1031 exchange is a swap of one real estate investment property for another that allows capital gains taxes to be deferred. It's named after Section 1031 of the Internal Revenue Code (IRC), and is often used by real estate agents, title companies, investors, and more.

The process can only be made with like-kind properties, meaning the exchanged properties must be similar in nature, such as one commercial property for another.

The Internal Revenue Service (IRS) rules limit its use with vacation properties, which may be a problem for some investors.

A 1031 exchange can be used by business owners or property 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 homes for personal use, so if you're looking to swap your primary residence, this isn't the right option.

The provision is sometimes known as the Starker Loophole, or a Starker exchange, which refers to the type of like-kind exchange that qualifies under Section 1031.

By using a 1031 exchange, you can defer federal taxes on the gains from the sale of property if the proceeds are reinvested in other properties.

To qualify for a 1031 exchange, the properties involved must be like-kind, meaning they're both real estate properties in the United States.

You have a strict timeline to follow: within 45 days of selling your property, you must designate the replacement property in writing to the intermediary. You can designate up to three properties, but you must eventually close on one of them.

Here are the key time limits to keep in mind: 45 days to nominate potential replacement properties, and 180 days to acquire the replacement property. If you need to identify more than three properties, it's best to consult with a 1031 facilitator.

A related party transaction is allowed, but it's subject to certain restrictions. If you're selling to a related party, you must meet the 2-year holding requirement for both parties, and the related party must also have a 1031 exchange. Alternatively, the taxpayor's deferment of capital gain must be less than or equal to the seller's taxable gain from selling the property.

To begin a 1031 exchange, you'll want to call your Exchange Facilitator, who will ask questions about the property being relinquished and any proposed replacement property. The initial discussion will vary, but you should be prepared to provide information about the parties involved.

You'll need to have information about the parties to the transaction, such as names, addresses, phone numbers, file numbers, and so on. This will help your Exchange Facilitator understand the details of your exchange.

There is no one-size-fits-all approach to structuring a 1031 exchange. Different companies will request varying levels of detail, but a proactive approach is often the most effective.

Here are the key time requirements to keep in mind:

From the time of closing on the relinquished property, you have 45 days to nominate potential replacement properties and a total of 180 days from closing to acquire the replacement property.

Closing costs can be a significant portion of the exchange process, but not all costs are created equal. The IRS has specific rules about what costs can be paid with exchange funds.

Some closing costs, like sales commission, legal fees, and appraisal fees, are considered Normal Transactional Costs and can be paid with exchange funds. These costs are a reduction of boot and increase in basis, which means they won't be subject to capital gains tax.

Other costs, like inspection/testing fees, points, and mortgage insurance, are also considered Normal Transactional Costs and can be paid with exchange funds. This list includes many common closing costs, and it's worth noting that these costs are typically non-taxable.

Here's a list of Normal Transactional Costs that can be paid with exchange funds:

If you need to pay a Non Exchange Expense, you can do so at closing, but you'll owe capital gains tax on the amount paid. This is a good reminder to carefully review your closing costs and ensure you're not jeopardizing the exchange by taking money out for non-allowable expenses.

To qualify for a 1031 exchange, the property being exchanged must be held for productive use in a trade or business, or for investment purposes. This is the key to unlocking the tax benefits of a 1031 exchange.

Real estate that is used for personal use, such as a primary residence, does not qualify for a 1031 exchange. The property must be used for business or investment purposes to meet the requirements.

In a 1031 exchange, the exchanged property and the replacement property must both be like-kind, meaning they are similar in nature and used for the same purpose.

Like-kind real estate is defined by Section 1031 as property held for productive use in a trade or business or for investment purposes. This means you can exchange one property for another of similar type, such as swapping a building for another building.

To qualify as like-kind, the replacement property must also be subject to depreciation, which means it can't be undeveloped land. If you swap a building for unimproved land, you'll trigger depreciation recapture.

The key is to continue using the replacement property in a trade or business or for investment purposes, just like the original property. This ensures you can defer the tax on depreciation recapture and capital gains.

If you own a vacation home, you might be wondering if you can use it for a 1031 exchange. To qualify, you'll need to rent it out and generate income, as a regular vacation home won't qualify unless it's rented out and generates an income.

To meet the IRS's requirements, you'll need to rent the property to another person for a fair rental for 14 days or more. You can't just list the property for rent without having tenants, or it won't qualify for a 1031 exchange.

You can't move into the property right away if you want to use it as your new second or principal home. To meet the safe harbor rule, you must rent the dwelling unit to another person for a fair rental for 14 days or more, and your personal use of the dwelling unit cannot exceed 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

Here are the specific guidelines for meeting the safe harbor rule:

If you acquire property in a 1031 exchange and later attempt to sell that property as your principal residence, the exclusion will not apply during the five-year period beginning with the date when the property was acquired in the 1031 like-kind exchange.

Between Related Parties, the rules get a bit more complicated. A related party transaction is allowed, but it's heavily restricted and scrutinized by the IRS to prevent Basis Shifting.

The definition of a related party is defined by IRC 267b, and it includes siblings, spouse, ancestors, lineal descendants, a corporation 50% owned either directly or indirectly, or two corporations that are members of the same controlled group.

If you're selling investment property to a related party, there's a 2-year holding requirement for both parties. This is to ensure that the property has been held for a significant amount of time before being sold.

The related party must also have a 1031 Exchange, or the taxpayer's deferment of capital gain must be less than or equal to the seller's taxable gain from selling the property.

Here are some exceptions to the two-year rule for 1031 exchanges between relatives:

You can exchange a domestic property for a domestic property, but not for a foreign property. This is because property located in the United States is not considered "like-kind" to property located in a foreign country.

It is not possible to exchange out of the United States into foreign property, and vice-versa, unless you're considering exchanging from the States into a US territory.

Fourteen US territories are eligible for exchange, including American Samoa, Baker Island, Guam, and many others.

It's essential to speak with your legal council when considering this option.

You must notify the IRS of the 1031 exchange by compiling and submitting Form 8824 with your tax return in the year when the exchange occurred. This form requires detailed information about the properties exchanged, including descriptions, dates, and values.

To complete the form correctly and without error is crucial, as failing to do so can result in a big tax bill and penalties. The IRS will scrutinize your submission to ensure you've followed the rules.

A 1031 exchange only delays taxes; it doesn’t eliminate them. A tax bill eventually comes due if you sell the replacement property and don’t reinvest the proceeds into a new property with another 1031 exchange.

If you receive cash from a 1031 exchange, it will be taxable as a capital gain.

Cash left over after an exchange is known as "boot" and can have serious tax implications. The difference in debt between your old and new property can also be taxed as income.

For example, if you sell a property with a $1 million mortgage and buy a new one with a $900,000 mortgage, the $100,000 difference would be taxed as income.

You must consider mortgage loans or other debt on the property you relinquish and any debt on the replacement property to avoid tax issues.

Failing to consider loans can lead to trouble with 1031 exchanges.

You must file Form 8824 with your tax return in the year the exchange occurred to notify the IRS of the 1031 exchange.

The form requires you to provide descriptions of the properties exchanged, dates when they were identified and transferred, and other important details to ensure accuracy and avoid potential penalties.

You're also required to disclose the adjusted basis of the property given up and any liabilities you assumed or relinquished, so keep all related documents handy.

Failing to complete the form correctly can result in a big tax bill and penalties, so it's essential to get it right.

A 1031 exchange only delays taxes; it doesn't eliminate them, and a tax bill eventually comes due if you sell the replacement property and don't reinvest the proceeds into a new property with another 1031 exchange.

You must report the transaction to the IRS using Form 8824 to maintain the transaction's tax-deferred status, and file the form with your annual income tax return for the year in which the exchange was completed.

Form 8824 asks for details about the properties exchanged, dates of the relevant transactions, and more, so be prepared to provide accurate and complete information.

Even though the tax is deferred and no gain or loss is recognized, the 1031 exchange must be reported on Form 8824, and the gain recognized from the boot is reported on Form 8949, Schedule D (Form 1040), or Form 4797, as applicable.

Choosing a Qualified Intermediary is a crucial step in a 1031 exchange, and it's essential to select someone experienced and reliable.

A qualified intermediary can't be a relative or anyone you've had a formal relationship with, such as an agent, broker, accountant, attorney, or employee, within a two-year period before the exchange.

There are special rules for 1031 exchanges that cover certain transactions and situations. These rules can be complex and are worth understanding before entering into a like-kind exchange.

One special rule is that there can be many twists and turns involved with a 1031 exchange. This is why it's essential to be aware of the special rules that apply to your specific situation.

Some common special rules include those that cover certain transactions and situations, such as multiple property exchanges.

Special rules can be tricky, but understanding them can save you a lot of headaches down the line.

Depreciable property has special rules when it comes to exchanges, which can trigger a profit known as depreciation recapture.

You might have heard of the 1031 provision, but did you know that swapping one vacation home for another can delay recognition of gain, allowing you to potentially use the $500,000 capital gain exclusion later on.

To fully avoid depreciation recapture following a 1031 exchange, the replacement property must also be subject to depreciation, such as a building on improved land.

You have 45 days to designate the replacement property in writing to the intermediary, specifying the property you want to acquire, or it will spoil the 1031 treatment.

If you're considering a 1031 exchange, it's essential to understand these special rules and timing requirements to avoid any surprises or penalties.

You can cancel an exchange, but it's essential to understand the rules and timeframes involved.

The cost and timeframe for terminating a deal vary from facilitator to facilitator, so it's crucial to check with your facilitator first.

You can terminate an exchange at any time prior to the close of the relinquished property sale, as long as you don't have actual or constructive receipt of the exchange proceeds.

After the 45th day, you can terminate the exchange only if you've acquired all the property you're entitled to under section 1031 rules.

After the 180th day, you can also terminate the exchange, regardless of whether you've acquired all the property.

Here are the specific times when you can terminate an exchange:

Section 1031 and Section 1033 are two distinct code sections that offer different benefits for taxpayers.

IRC 1031 provides more flexibility on the type of replacement property that can be acquired.

While both sections allow for the deferment of capital gain on property, they operate and impact taxpayers differently.

IRC 1033 offers more flexibility on time constraints and receipt of funds.

Identifying your replacement property can be a challenge, especially when you're under a tight deadline. As an Exchangor, you must provide an "unambiguous description" of the potential replacement property on or before the 45th day after closing on the relinquished property.

A legal description or property address will suffice, but you must be specific. You can't just vaguely mention a neighborhood or city - you need to pinpoint the exact location.

If you're planning to identify multiple properties, you have some flexibility. You can identify up to three properties of any value with the intent of purchasing at least one.

Alternatively, you can identify more than three properties, but there are some restrictions. If the aggregate value of these properties exceeds 200% of the market value of the relinquished property, you'll need to acquire 95% of the market value of all identified properties.

Here are the guidelines for identifying multiple properties:

You can pay closing costs with exchange funds, but only for Normal Transactional Costs, which include sales commission, appraisal fees, and legal fees.

To be fully tax deferred, you must re-invest in a property that is equal to or greater than the sales price of the property you are relinquishing.

The IRS requires you to carry all equity from the relinquished property forward into a new replacement property to fully defer all taxes.

You can't refinance a property in anticipation of an exchange, as the IRS may challenge it.

Here's a breakdown of Normal Transactional Costs that can be paid with exchange funds:

If you take money out of the exchange for a Non Exchange Expense, you'll be liable for paying capital gains tax on the difference.

You have 45 days to nominate potential replacement properties after closing on the relinquished property. This is a critical deadline, and missing it can jeopardize the entire exchange.

The IRS requires you to identify the replacement property prior to midnight on the 45th day. This means you need to act fast, but don't worry, you can nominate three properties as long as you eventually close on one of them.

You'll have a total of 180 days from closing to acquire the replacement property. This is a long time, but it's essential to remember that the two time periods run concurrently. This means you start counting when the sale of your property closes.

Here are the key deadlines to keep in mind:

You can cancel an exchange at any time prior to the close of the relinquished property sale, or after the 45th day if you've acquired all the property you're entitled to under section 1031 rules. However, canceling an exchange can be complex, and it's best to consult with a qualified intermediary or tax professional.

If you've sold your relinquished property, you must complete your 1031 exchange by the earlier of 180 calendar days or the due date (with extensions) of your return. This means you might need to file for an extension on your taxes to have the full 180-day exchange period.