Lighten your tax burden with a 1031 exchange
1031 tax exchanges explained
- 1031 exchanges allow investors to defer capital gains taxes
- Property must be exchanged with like-kind property
- A qualified intermediary is almost always needed to facilitate the transaction
If you sell an investment property, the proceeds are subject to capital-gains taxes. One way to defer those taxes is through what’s called a 1031 exchange, also known as a like-kind exchange.
A 1031 exchange is a tax mechanism that allows investors to defer taxes when they use the proceeds of a sale to purchase similar property. It is available for investment properties, but not for personal-use properties such as a primary residence or vacation home. Although 1031 exchanges aren’t limited to real estate, they are mostly used with commercial real estate transactions.
How 1031 exchanges work
When you sell a property and use the proceeds to purchase similar property — or “like-kind” property, as the Internal Revenue Service puts it — you don’t have to pay capital gains taxes until you sell the new property.
If you sell the new property and use those proceeds to buy another like-kind property, you can defer capital gains taxes again. You can defer the taxes for as long as you exchange the proceeds of a sale for like-kind property — there is no limit. Once you keep the proceeds or put them toward a use that isn’t “like-kind,” you’ll owe capital-gains taxes.
What is ‘like-kind’ property?
The IRS definition of “like-kind” is broad, described as “property of the same nature, character or class.” The agency goes on to say that quality or grade does not matter, and that most real estate is considered like-kind to other real estate. For example, the agency states that improved property with a residential rental house is like-kind to vacant land.
An exception is that property located within the U.S. is not considered like-kind with foreign property. You may exchange two domestic properties, or you may exchange properties in two foreign countries, but you may not exchange a U.S. property for a foreign one, or vice versa. Additionally, improvements conveyed without land — called a leasehold interest — are not like-kind to land. Other property that doesn’t qualify as like-kind under IRS rules include inventory or stock in trade; stocks, bonds and other notes; securities or debt; partnership interests; and certificates of trust.
Although both real property — that is, real estate and the legal rights associated with that real estate — and personal property can qualify for a like-kind exchange, it’s important to note that real property and personal property cannot be considered like-kind to each other. Additionally, the rules governing what constitutes like-kind are more restrictive for personal property than for real property. The IRS uses vehicles as an example: Cars are not like-kind to trucks.
To implement a 1031 exchange, you’ll almost certainly need the services of a qualified intermediary (QI) — an independent and neutral third party that facilitates the transfer of property between parties, holding the proceeds of the exchange in an escrow account. A QI cannot be a parent, child or sibling, nor can it be anyone considered an agent of the property holder — such as an attorney, real estate agent or broker — who has represented the property owner within the past two years.
It is possible to perform a 1031 exchange without a QI if two parties directly exchange the property with each other. But it is rare for like-kind exchanges to take place this way, and even then it can be a good idea to use a QI as a contingency.
How to find a qualified intermediary
If you’re in need of a QI, the Federation of Exchange Accommodators (FEA) is a good resource for finding one. The FEA is a national trade organization representing QIs, as well as their legal and tax advisors, and affiliates who are directly involved in 1031 exchanges. The organization maintains a search engine on its website to help investors find QIs to facilitate like-kind exchanges.
Because 1031 exchanges can be complicated and a single mistake can leave you liable for capital gains taxes, it’s also a good idea to consult a tax attorney. There are many professional associations that maintain member directories to help one find a tax attorney, including the National Association of Tax Professionals and the National Society of Tax Professionals. The IRS maintains a list of other associations for tax professionals on its website.