If you currently own an investment property, a 1031 exchange may be the perfect real estate option if you want to buy another property while selling off your present one. 

A 1031 exchange is a tax-deferred exchange that allows you to suspend capital gains taxes as long as you buy another “like-kind” property. This exchange technique is used by some of the most successful real estate investors and can be profitable in numerous situations. The following is a guide to the 1031 exchange and its workings.

Here, you’ll learn what the 1031 exchange is, what happens when you sell a 1031 exchange property, and the various 1031 exchange rules.

What Is the 1031 Tax Exchange? 

A 1031 exchange is a tool that allows real estate investors to trade an investment property for another and suspend the capital gains tax that they’re required to pay at the time of sale. This method is common with real estate investors looking to upgrade properties without paying taxes for the profits.

1031 exchange is also commonly referred to as a like-kind exchange or a Starker exchange and refers to real estate properties including land and buildings.

Suppose you’ve been asking “what happens when you sell a 1031 exchange property?” The answer is: “It depends. If you purchase another like-kind property after the sale of the property and apply for tax deferment, you’ll not be taxed on the sale, but if you don’t acquire a like-kind property within the stipulated time frame, you’ll be required to pay tax gains.

What Is 1031 Exchange in Real Estate?

The 1031 exchange in real estate is any property held for productive use in a business, trade, or investment. Any investment property can be traded for another type of investment property. For instance, a single-family residence can be swapped for a duplex, an office for apartments, or raw land for a shopping center. Any combination is allowed. The exchanger can alter investment strategies to fulfill their needs.

You can’t trade partnership shares, stocks, notes, bonds, trust certificates, or other such items in 1031 exchange. Furthermore, the real estate investor can’t trade investment property for their residence, property in another country, or “stock in trade.” Properties built by a developer and offered for sale are stock in trade. If a real estate investor buys “fixer-uppers” and sells them as soon as they’re better, the properties might be seen as stock in trade and can’t be exchanged.

1031 Exchange Rules

There are four 1031 exchange rules that must be met for a successful tax deferral. Let’s look at what each rule involves:

Rule #1: Must Be Like-Kind Property

The acquired and relinquished properties must be like-kind properties, which means that they must be identical in nature or character, although they can differ in grade or quality. As it applies to real estate, almost any property can be traded with nearly any other kind. 

For example, as long as both or all properties involved in the exchange are situated within the United States, this also means that you can trade one large property for several smaller ones and vice versa. It’s pertinent to note that certain rules apply for exchanges of one property for multiple replacement properties.

Rule #2: Investment or Business Properties Only

1031 exchanges can only involve business or investment properties. Personal properties such as your main residence don’t qualify. Also, the personal property, in general, is no longer qualified for 1031 exchange due to the Tax Cuts and Jobs Act of 2017.

Rule #3: Greater or Equal Value Property Only

To have all income taxes deferred in the 1031 exchange, the acquired property needs to have a net market value and equity equal to or greater than the relinquished property. 

So, for example, if your property is worth $2,000,000, you’d need to pick a replacement property worth at least that much or a combination of properties whose total value equals or exceeds $2,000,000. You can choose to have more than one replacement property as part of your like-kind exchange, so long as when their values are added up, it isn’t more than 200% of the value of the relinquished property value.

You can do a partial 1031 exchange, where the property you relinquish is worth more than the acquired property, but you must pay income taxes on the difference, which is referred to as the “boot.”

For example, if you sell a property for $2,500,000 and want to exchange it for a property worth $1,500,000, you would pay the standard amount of applicable income taxes on the $1,000,000 difference.

Rule #4: Same Taxpayer Name

The title of the relinquished property and the name on the tax return must match the name on the purchasing documents for the acquired property. The only exception to this rule is if the real estate investor uses a single-member limited liability company to sell the relinquished property and their name to buy the replacement property.

IRC 1031 Tax-Deferred Exchange Requirement

The sale and the purchase transactions must be structured accurately to qualify for tax-free exchanges under section 1031. Then the Qualified Intermediary, sometimes referred to as the  1031 Exchange Facilitator or the 1031 Exchange Accommodator, will complete the essential legal documents to ensure that you obey all laws, rulings, and regulations.

The Qualified Intermediary must be assigned to oversee the sale, purchase agreement, and the escrow instructions, if any, before the end of your sale and purchase transactions. Your transaction will not qualify for 1031 exchange if either transaction closes without your Qualified Intermediary being properly assigned to both transactions. 

Bottom Line

That’s a wrap! We believe we have done justice to the question “what happens when you sell a 1031 exchange property”. Simply put, 1031 exchanges are like taking a loan from the IRS without paying any interest. Instead of paying tax any time you sell or buy a property, you can put that additional money to work immediately and enjoy higher current rental income while growing your portfolio faster than would otherwise be possible. If you have decided to take advantage of this great opportunity, you can find 1031 exchange real estate here.

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