By Brandon Smith, CPA
1. What is the 1031 Exchange?
The name 1031 Exchange comes from the tax code section 1031 and in layman’s terms means that you can defer paying taxes when you sell real property used for business or investment and use the proceeds of the sale to buy like-kind real property.
Whenever you sell business or investment property, normally you would have a gain and you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange.
2. Why would you want a 1031 Exchange?
You may wish to diversify your assets.
You may be seeking a property that has better returns.
You may want to consolidate several properties into one or divide a single property into several.
You may want to reset the deprecation clock.
3. How do you qualify for a 1031 Exchange?
There are a few rules that must be followed to ensure you qualify for the 1031 Exchange.
Property Use – Both the old and new property must qualify as business or investment use. The general holding period is for at least 1 year.
45 Day Rule – You must identify a replacement property in writing within 45 days.
200% Rule – The total value of the replacement properties must not exceed 200% of the value of the original property.
180 Day Rule – You must complete the transaction within 180 days or the filing date of your tax return, whichever is earlier.
Qualified Intermediary – You must use a qualified intermediary to facilitate the transaction. They hold the funds and oversee the 1031 Exchange. They can have no formal relationship with the parties of the exchanging properties.
Title Holding – The title of the replacement property must be exactly the same as the original property.
Reinvestment Requirement – The replacement property must be equal or higher value to the original property to defer all of the capital gains tax.
4. Basic Example
Let’s just say that you bought an investment property for $200,000, depreciated $50,000, and sold it for $250,000. You would have a total capital gain of $100,000. You decide to participate in the 1031 Exchange and buy a replacement property worth $300,000. Since you have the $100,000 deferred capital gain, your basis in the new property is now $200,000.
If the replacement property is of lesser value than the property sold, then the difference is taxable.
5. Reporting
You must report an exchange to the IRS on Form 8824, Like-Kind Exchanges and file it with your tax return for the year in which the exchange occurred.
Form 8824 asks for:
Descriptions of the properties exchanged
Dates that properties were identified and transferred
Any relationship between the parties to the exchange
Value of the like-kind and other property received
Gain or loss on sale of other (non-like-kind) property given up
Cash received or paid; liabilities relieved or assumed
Adjusted basis of like-kind property given up; realized gain
If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.
And that’s it! Those are the 5 things you need to know about the 1031 exchange. We hope you found this information helpful!
About Brandon Smith, CPA
Brandon Smith is a Certified Public Accountant, QuickBooks Online Certified ProAdvisor and founder of Smith, CPA & Financial Consulting, Inc.
DISCLAIMER
This blog does not constitute as tax advice. Please contact your CPA or tax professional if you are considering entering into a 1031 Exchange.
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