A 1031 exchange, named for the relevant section of the IRS tax code, is simply an investment swap. You trade one investment for another similar asset. For this reason, a 1031 exchange is also known as a like-kind exchange. The key benefit is that 1031 exchanges are done without cashing in or selling the original asset, thus avoiding a taxable event. Most 1031 exchanges are used for real estate, but you can exchange other types of investments. And as with all tax breaks, there are important issues to consider before "1031-ing" anything. Yes: The investment industry has transformed a noun into a verb.
How It Works
You can choose to exchange an investment for another of like kind. Say you own a house that you rent out and the value has appreciated since you purchased it. If you sell, you would have to pay capital gains tax on the profit. If you do a 1031 exchange to buy a similar piece of real estate you can "roll over" the profit tax-deferred. This means you can invest the full proceeds of the sale into the second investment. You can keep swapping as long as you follow the rules regarding timing and target property and never pay tax until you take cash out of the investment. When filing your tax return you'll report the exchange on Form 8824 (Like-Kind Exchanges).
Three-Party or "Starker" Exchanges
Because it's unlikely you'll find someone who has an investment you want who also wants what you've got, the IRS allows you to place the proceeds of your "sale" with an intermediary via a qualified exchange accommodation arrangement (QEAA) while you arrange the purchase of a new investment. These are also called delayed exchanges and require fairly quick turnaround of the money in order to avoid being taxed as a regular sale. For this reason, you must specify your replacement property within 45 days of the original sale in writing to the intermediary holding the funds. You may choose several potential targets, but if you don't close on one of them within 180 days, you'll lose the 1031 tax-deferred status.
What Property Qualifies?
You can only 1031 real estate that is not for personal use, so it cannot be used for exchanging your primary residence. If you own a rental unit, ranch, parcel of land, apartment building, or similar real estate, you can swap out of that into just about any other type of real estate. Despite the "like-kind" designation, you don't have to swap a ranch for a ranch; you can move that money into a shopping mall. You cannot use 1031 exchanges for inventory, corporate stock, bonds, notes or other debt instruments. Some exceptions: property in the United States is not considered like-kind for property outside of the United States, and for some reason, livestock of different sexes is not considered like-kind. Go figure.
Beware Partial Cash Outs
In the event your property and the target asset are not of equal value, any cash portion of the transaction will be taxed at the appropriate capital gains rate. Example: You sell a rental property for $1 million, but the replacement property only costs $900,000. You will be taxed on up to $100,000 in capital gains depending on your basis in the original property. If the exchange includes a portion of property that is not of like kind, that portion will be taxed. Example: You swap a ranch and livestock for undeveloped land of the same value. The livestock and the real estate are not like-kind investments, so the transaction incurs a tax on the value of the livestock up to the amount of capital gain realized.
Exchanges With Related Parties
The IRS has specific rules regarding exchange of property between related parties. You must hold property exchanged between related parties for at least two years before selling it. Otherwise, the tax-free 1031 exchange transaction is voided. Any gain on the exchange -- as well as gains on the eventual sale of the property -- will then be taxable for both parties. There is no restriction on sales of such property, other than the holding-period requirement. The IRS defines a related party as a family member or any entity in which an individual owns more than 50 percent stake. Thus you are subject to related-party rules if you exchange property for another asset in which you own a share greater than half, as well as one owned by a family member.
Naomi Smith has been writing full-time since 2009, following a career in finance. Her fiction has been published by Loose Id and Dreamspinner Press, among others. She holds a Master of Science in financial economics from the London School of Economics and a Bachelor of Arts in political economy from the University of California, Berkeley.