Investors

What is a 1031 Exchange?

In real estate, a 1031 exchange is a swap of one investment property for another that allows captial gains taxes to be deferred.

IRS Section 1031 has many moving parts that real estate investors must understand before attempting its use. An exchange can only be made with like-kind properties and IRS rules limit use with vacation properties. There are also tax implications and time frames that may be problematic. Still, if you're considering a 1031—or are just curious—here is what you should know about the rules.

Property Idenfication Timeline

In a typical Internal Revenue Code (IRC) §1031 delayed exchange, commonly known as a 1031 exchange or tax deferred exchange, a taxpayer has 45 days from the date of sale of the relinquished property to identify potential replacement property. This 45-day window is known as the identification period. The taxpayer has 180 days (shorter in some circumstances) to acquire one or more of the identified properties, which is known as the exchange period. Property(ies) actually acquired within the 45-day identification period do not have to be specifically identified.

Key Takeaways

A 1031 exchange is a swap of properties that are held for business or investment purposes.

The properties being exchanged must be considered like-kind in the eyes of the IRS for capital gains taxes to be deferred.

If used correctly, there is no limit on how many times or how frequently you can do 1031 exchanges.

The rules can apply to a former primary residence under very specific conditions.

The rules can apply to a former primary residence under very specific conditions.

What Is Section 1031?

Broadly stated, a 1031 exchange is a swap of one investment property for another. Although most swaps are taxable as sales, if yours meets the requirements of 1031, you'll either have no tax or limited tax due at the time of the exchange.

In effect, you can change the form of your investment without (as the IRS sees it) cashing out or recognizing a capital gain. That allows your investment to continue to grow tax-deferred. There's no limit on how many times or how frequently you can do a 1031. You can roll over the gain from one piece of investment real estate to another, to another, and another. Although you may have a profit on each swap, you avoid tax until you sell for cash many years later. Then, if it works out as planned, you'll pay only one tax, and that at a long-term capital gains rate (currently 15% or 20%, depending on income—and 0% for some lower-income taxpayers).2

Most exchanges must merely be of "like-kind"—an enigmatic phrase that doesn't mean what you think it means. You can exchange an apartment building for raw land, or a ranch for a strip mall. The rules are surprisingly liberal. You can even exchange one business for another. But there are traps for the unwary.

The 1031 provision is for investment and business property, although the rules can apply to a former primary residence under certain conditions. There are also ways you can use 1031 for swapping vacation homes—more on that later—but this loophole is much narrower than it used to be.