What is a 1031 Exchange?
A 1031 Exchange, also known as a Like-Kind Exchange, lets you defer capital gains tax when selling business or investment property by reinvesting the proceeds into other real estate. This process is defined under Section 1031 of the Internal Revenue Code (IRC). 1031 Exchanges are commonly referred to by other names as well:-
Delayed Exchange
Section 1031 Exchange
Like-Kind Exchange
Tax-Free Exchange
Real Estate Exchange
Real Property Exchange
Starker Exchange
Tax Deferred Exchange
Real Estate Swap
Forward Exchange
Simultaneous Exchange
A 1031 Tax Deferred Exchange provides taxpayers with one of the final opportunities to build wealth and reduce taxes. By completing a 1031 Exchange, the taxpayer ("Exchanger") can sell investment or business-use property, acquire a Replacement Property, and defer the taxes that would typically apply to the sale.
1031 Exchanges have been part of the tax code since 1921. Section 1031 allows taxpayers to exchange business or investment assets for other like-kind assets without triggering taxable gains from the sale. As a result, the taxes that would normally be due are deferred.
Types of Properties Commonly Used in 1031 Exchanges
Agricultural Land & Farmland
Commercial Property
Investment Property
Vacation Rental Property (Airbnb & Vrbo)
Conservation Property
Timberland Investment Property
Oil
Gas
Mineral
Water and Ditch Rights
DSTs
REITs
What Can/Cannot be Exchanged?
Approved:
Real property: This includes buildings and land, both commercial and residential.
Investment property: This applies to properties held for generating income, such as rental properties.
Disapproved:
Personal property: This includes your primary residence, personal use vacation homes, and other personal belongings.
Intangible property: This includes stocks, bonds, and other financial instruments. This does not apply to DSTs and REITs as these are tied to real property.
Put simply, you can do a 1031 Exchange or consider a 1031 Exchange when you do not live in a property you own and would like to sell the property and use those proceeds in a new real estate endeavor.
1031 Exchange Concepts
What is Internal Revenue Code Section 1031?
Since 1921, federal tax law under Internal Revenue Code (IRC) Section 1031 has allowed taxpayers to exchange business-use or investment properties for other like-kind properties without recognizing taxable gain on the sale of the original asset. As a result, the taxes that would typically apply to the sale are deferred. Most 1031 Exchanges involve separate buyers and sellers, rather than simple swaps between two parties. To meet the 'exchange' requirement, an independent third-party Qualified Intermediary (QI) is needed. The QI holds the sale proceeds on behalf of the taxpayer during the exchange, uses the funds to purchase like-kind replacement properties, and returns any unused funds to the taxpayer once the exchange is complete. 1031 Exchanges must be finalized within 180 days. Taxpayers must recognize any gain and pay taxes on unused funds or when they eventually 'cash out' of the property. In 2018, Section 1031 was amended to limit eligibility for exchanges to real estate only.
Explain 1031 Like-Kind Exchanges?
Like-Kind Exchanges, also known as Tax Deferred Exchanges, are governed by IRC Section 1031. Since 1921, Section 1031 has allowed taxpayers to exchange business-use or investment properties for other like-kind business or investment properties without having to recognize taxable gain on the sale of the original assets. As a result, the taxes that would normally apply to the sale are deferred. Section 1031 transactions can range from simple 2-party 'swaps' to more complex, non-simultaneous exchanges involving separate buyers and sellers. Qualifying assets include commercial, agricultural, and rental real estate. For non-simultaneous exchanges, the use of an independent third-party Qualified Intermediary (QI) is required. The QI holds the sale proceeds for the taxpayer’s benefit during the exchange, uses the funds to purchase like-kind replacement properties, and returns any unused funds to the taxpayer at the end of the exchange. Section 1031 Exchanges must be completed within 180 days. Taxpayers will recognize gain and owe taxes on any unused funds or when they eventually 'cash out' of the property.
Who uses 1031 Exchanges?
Like-Kind Exchanges are utilized by a wide range of businesses, including manufacturers, real estate investors, companies in construction, trucking, rail, marine, and equipment leasing, as well as farmers, ranchers, and individuals. 1031 Exchanges are one of the few tax incentives available to taxpayers of all sizes. A recent industry survey found that 60% of exchanges involve properties valued under $1 million, with more than a third valued at less than $500,000. Qualified Intermediaries (QI) play a key role in facilitating non-simultaneous tax-deferred exchanges for all types of taxpayers, from individuals with modest means to high-net-worth investors, and from small businesses to large corporations.
Why 1031 Like-Kind Exchanges?
After completing a Like-Kind Exchange, the owner of business-use or investment real estate ("investor") gains additional capital to acquire replacement properties. This can lead to increased cash flow and/or greater potential for asset appreciation. Additionally, the broader economy benefits, as the investor must fully reinvest in the Replacement Property to receive full tax deferral. These transactions generate taxable income through title and escrow fees, real estate commissions, legal and accounting fees, and the purchase of goods and services if improvements are made to the replacement property. Local and state governments also benefit from the fees and taxes generated by these real estate transactions. Since real estate in foreign countries is not considered like-kind to U.S. real estate, Section 1031 encourages reinvestment and job growth within the U.S. borders.
What are the tax policies upon which 1031 Exchanges are based?
Since its introduction in 1921, Section 1031 has remained a part of the tax code despite ongoing Congressional review, because it is grounded in sound tax policy that encourages continued investment by taxpayers.
Section 1031 aligns with the principles of efficiency, neutrality, fairness, and simplicity within the tax system.
It fosters business decisions that contribute to U.S. job creation and the overall growth of the U.S. economy.
Section 1031 also supports the efficient use of productive capital and operational cash flow.
Exchanges under Section 1031, facilitated by Qualified Intermediaries, are neither abusive nor administratively burdensome for the IRS or taxpayers.
The benefits of Section 1031 are widely utilized by a diverse range of taxpayers, from individuals to partnerships, limited liability companies, and corporations, across various industries.
Is the capital gains tax eliminated with a 1031 exchange?
While 1031 Exchanges allow for tax deferral, they do not eliminate taxes. These legitimate transactions serve as a key tax planning tool. Taxes are paid in one of the following ways:
Upon the sale of the replacement asset;
Gradually, through higher income taxes due to lost depreciation; or
Upon inclusion in a decedent’s taxable estate, where the value of the replacement asset could be subject to estate tax at a rate more than twice the capital gains tax rate
