What is a 1031 Exchange?

If you are considering selling a piece of property that will result in a significant profit and also a large tax bill, you may want to think about a 1031 exchange.

A 1031 exchange is a transaction that allows an investor to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds from the sale into a similar property. 

Qualifying for a 1031 Exchange

To qualify for a 1031 exchange, investors must adhere to a strict set of IRS rules and regulations. 

The exchanged properties must be "like-kind," meaning investors must use them for investment or business purposes. Additionally, the investor must identify potential replacement properties within 45 days of selling the original property and complete the purchase within 180 days. 

While 1031 exchanges can be complex, they offer a valuable way for investors to defer capital gains taxes and continue growing their portfolios.

Eligible Properties 

Once you've decided to defer your capital gains taxes by completing a 1031 exchange, the first step is identifying eligible properties. 

These "like-kind" properties include office buildings, retail storefronts, warehouses, agricultural land, and some minerals and natural resources. As long as the property is used for business or investment purposes, it's likely eligible for a 1031 exchange. 

Qualified Intermediary

The next step is to choose a qualified intermediary who will hold the proceeds from the sale of your property and then use those funds to purchase the new property. 

A qualified intermediary can be a bank, attorney, or registered broker-dealer. 

Once you've chosen your intermediary and identified the new property you'd like to purchase, you'll need to complete the exchange within 180 days. 

Common Types of 1031 Exchanges

A delayed exchange, also known as a Starker exchange or a 1031 exchange, is a transaction in which an investor sells one property and then uses the proceeds to purchase another property within a specific time frame. Delayed exchanges are commonly used to defer capital gains taxes when selling investment properties. 

There are three main types of delayed exchanges: 

• Delayed exchange with one property being sold and later replaced
• Delayed/simultaneous exchange with the replacement property purchased at the same time as the current property is sold 
• Delayed reverse exchange with the replacement property purchased before the existing property is relinquished 

In a build-to-suit exchange, the investor works with a qualified intermediary to purchase the replacement property before selling the relinquished property. This type of exchange can be used when the perfect replacement property is not currently available on the market.

The Bottom Line

Although a lot of paperwork is involved in a 1031 exchange, the result is worth it: you can defer your capital gains taxes and reinvest your money into a new property without incurring any immediate tax liability.