What is a 1031 Exchange?

If you own investment property and are considering selling it and purchasing another property, a 1031 tax-deferred exchange is something you should familiarize yourself with. 

In simple terms, a 1031 exchange, also referred to as a Starker exchange is a swap of one investment property for another one that is of value or greater value than the property being sold.

The term 1031 exchange comes from the Internal Revenue Service (IRS) code Section 1031. 

There is a great deal of confusing and inaccurate information out there concerning what type of property will qualify for a 1031 exchange. 

This article is designed to help you understand what the 1031 exchange is, the criteria that must be followed, and what properties qualify for the 1031 tax-deferred exchange. 

What is the 1031 Exchange?

The 1031 exchange is a procedure that permits the owner of an investment property to sell it and buy a like-kind property while deferring any capital gains tax.

Capital gains on the property are not being eliminated, they are being deferred. If and when an investor sells their property they will be responsible to pay those deferred gains.

Investors can use the 1031 exchange repeatedly, allowing them to upgrade to new properties while continuing to defer any capital gains.

What Criteria Must Be Met?

Criteria that must be met for the property to be like-kind are:

• Properties must both be in the United States, but do not need to be in the same state. 

• The exchanger must currently use the original property for business, as an investment, or some production of income.

• The exchanger must use the replacement property for business, as an investment, or some production of income. 

• The replacement property has to be identified within 45 days and received within 180 days.

What Properties Qualify For a 1031 Exchange

It is required that certain criteria are met for a property to be like-kind. Like-kind refers to the character and nature of the property. However, properties do not need to be the same type. In other words, you can exchange a commercial rental property for raw land.

Properties That Qualify

Some examples of properties that qualify for a 1031 exchange are:

• Farmland for improved real estate

• Raw land

• Oil royalties for a ranch

• Rental multi-unit apartment buildings

• Commercial or retail rental properties 

• Any property held for use in a trade or business for an investment

Properties That Do Not Qualify

Some examples of properties that do not qualify for a 1031 exchange are:

• Any property held for business inventory

• Residential fix-and-flip

• Vacant land used for residential development 

• Primary residences

How Much Money Must Be Reinvested?

To qualify for a 1031 exchange and to avoid taxes, investors must spend at least as much on the replacement property as the original property was sold for. 

For example, if you sell a property for $1.5 million, you must spend at least $1.5 million on your new property to defer taxes.

Acquisition costs count towards the total cost, as well.

Let’s use the example with a property sold for $1.5 million. You can buy a new property for $1.3 million if you spend $200,000 on legal fees and other acquisition costs. It will still be considered a $1.5 million investment. 

What Happens If You Don’t Reinvest Enough?

What happens when investors want to purchase a property that is lower in value than the original property?

The part of the exchange proceeds that are not reinvested is called a “boot.” This money is subject to capital gains. 

For example, an investor who sells a property for $1.5 million and buys a new property for $1.3 million - that $200,000 will be taxed. This is called a partial exchange.

Interested in learning more about 1031 Exchanges?

A 1031 exchange is a powerful tool for real estate investors. If you are in a position where you want to sell but are concerned about incurring a huge tax burden, this is a great option for you to unlock the equity you have in your current property and move it to other properties with more potential.

Glass House works with 1031 Exchange sellers and would be happy to discuss how we can help you! Contact us today