Understanding the 1031 Like-Kind Exchange Rules

At a glance

• The main takeaway: Internal Revenue Code (IRC) Section 1031, also sometimes referred to as a “like-kind” exchange, allows individuals and businesses to defer capital gains taxes if they reinvest the proceeds into other qualifying properties.
• Impact on your business: The 1031 like-kind exchange can expand a taxpayer’s opportunities for tax deferral and serve as a viable long-term tax-saving strategy for individuals investing in real estate.
• Next steps: Aprio’s Real Estate team can advise, provide strategies, and offer guidance to individuals navigating a 1031 like-kind exchange.

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The full story:

Internal Revenue Code (IRC) Section 1031, also referred to as the “like-kind” exchange, provides individuals with an exception by allowing them to defer capital gains if they reinvest the proceeds into other qualifying properties.

The 1031 like-kind exchange can be a viable long-term tax saving strategy for individuals investing in real estate. In this article, we explore the complexities of the 1031 like-kind exchange, timelines, rules, and eligibility.

How does a 1031 like-kind exchange work?

The 1031 like-kind exchange can be considered a tax break, as it allows individuals who have business or investment property to delay paying capital gains tax on the sale of their property used to buy a replacement property.

Types of 1031 exchanges

A 1031 exchange poses significant tax-deferment benefits that individuals can leverage when considering selling their business or investment property and purchasing a new one. You must be diligent and patient in complying with the terms of a 1031 exchange; taking the wrong approach or making a misstep could open you up to negative tax liability. It is crucial to consult with a qualified, credentialed tax advisor who can help create the best-possible scenario for your real estate transaction.

1031 exchange timelines and rules

To successfully defer capital gains taxes, the 1031 like-kind exchange process follows strict timelines and rules.

• Forward exchange or 45-day period: When you have completed the sale of a property through a Qualified Intermediary, you have 45 days to identify the replacement property and document your choice in writing.
• 180-day period: After identifying the replacement property, you have 180 days (from the sale of the old property) to complete the purchase of your replacement property through the Qualified Intermediary.
• Reverse exchange: In this case, you can buy a replacement property before selling the old property. The same rules of the 45- and the 180-day period apply. You may need to transfer the replacement property to an “exchange accommodation titleholder,” while identifying an old property you want to exchange within 45 days. You must complete the purchase within 180 days after the sale of your replacement property.

1031 like-kind exchange for estate planning

A 1031 like-kind exchange can be a great tax-saving opportunity for your heirs. If the owner of a property previously deferred gain through a 1031 exchange owns the property at death, the heirs may take the property at fair market value (known as a “step up”) and the deferred gain is never recognized.

Who qualifies for the 1031 exchange?

According to the Internal Revenue Service (IRS), owners of business or investment properties may qualify for the 1031 like-kind exchange. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts, and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties.

What property qualifies for a like-kind exchange?

Business or investment properties qualify for a 1031 like-kind exchange. Both properties must be similar enough to qualify for the “like-kind” treatment. Like-kind properties are properties of the same character or nature — as long as they are used in a business, investment, or trade. Properties that are for personal use, such as your primary residence or vacation home, do not typically qualify but can be turned into an investment property to be eligible for the exchange.

The IRS also identified certain types of property that are specifically excluded from Section 1031 treatment:

• Inventory or stock in trade
• Stocks, bonds, or notes
• Other securities or debt
• Partnership interests
• Certificates of trust

Is it possible to do a 1031 exchange on a principal residence or second home?

Personal residences do not qualify for the 1031 exchange as they’re specifically excluded by law. However, you can consider converting your residence into an investment property by renting it out, so it generates an income for a reasonable timeframe to make it eligible. The same rule applies if you plan to turn your vacation home eligible for a 1031 exchange.

The bottom line

A 1031 like-kind exchange is a tax-deferred strategy that individuals can leverage to build wealth. However, it might be a challenge to adhere to the specific and strict timelines and rules of the exchange. It’s best to consult with an advisor for proactive guidance and strategies that can help you increase equity and maximize the value of real estate transactions.

There are multiple strategies to defer taxes in your long-term plans for your properties. If you need help identifying the next steps after you have decided to sell your business or investment property, Aprio’s Real Estate team can advise and provide strategies for ensuring a valid 1031 like-kind exchange.

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