What are 1031 Exchanges and Are They Right For You?

There’s a lot of confusing things in Commercial Real Estate. There’s a lot of little behind-the-scenes pieces of a deal that can be very complicated for the normal layman.

One of those things is what’s called a “1031 Exchange.”

According to the IRC Section 1031 (a)(1):

“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”

Basically, a 1031 Exchange lets an investor sell a certain property, then take the leftover proceeds from that property and reinvest in a newer property and they can defer all capital gains from that deal.

If someone sells a property, they would typically have to pay taxes on the sale. In a 1031 Exchange, however, the investor or seller would be able to defer all those taxes of which they would previously have to pay.

According to a new code of the law, the sale has to be a “like-kind property” exchange. As in, the properties in the deal have to be of similar characteristics.

But why would someone use a 1031 Exchange?

The investor can use their property for things like Diversification, Cash Flow, Increase Depreciation or Estate Planning. Any of those motives are great for 1031 Exchanges.

People might want to move from something like Residential Real Estate to Commercial. This might be a place where a 1031 Exchange to invest in their first Commercial property would be an excellent motive for this Exchange.

Here’s a downside: the tax doesn’t go away.

You will still eventually have to pay taxes on the Exchange, because the 1031 Exchange simply defers the taxes from the Exchange, rather than erasing it.

There are also some exclusions to this Exchange.

Someone can’t do a 1031 Exchange with the intent to sell the exchanged property. The property should be exchanged with the intent to grow the property. They have to be held for long-term investment.

Again, in laymen terms, someone can’t simply exchange a “not-so-nice” property, fix it into something nice and with that gains value, then sell it for profit. That’s exempt in the 1031 Exchange code.

This is one of the most important parts of 1031 Exchanges. The taxpayer must have the intent to hold to property. The IRS could be ready to jump at any time if the taxpayer doesn’t hold the property for long enough and/or have enough of a paper trail to show the intent to hold the property as a long-term investment.

There are also time requirements for holding a 1031 Exchange. There’s a 45-day period and a 180-day period.

45-day period: Within 45 days of the initial sale of the property the investor must identify the replacement property.

180-day period: The sale/exchange of the two properties must be completed.

There are three main rules regarding the exchange. There is the “Three-Property Rule,” “200% Rule” and “95% Rule.”

The Three-Property Rule is the investor must show (in writing) three like-kind properties that could be exchanged for the original property.

The 200% Rule lets the investor identify unlimited replacement properties as long as their cumulative value doesn’t exceed 200% of the value of the property sold.

The 95% Rule lets the investor identify as many properties as they like as long as they acquire properties valued at 95% of their total or more.

There’s so much more to 1031 Exchanges that is way too complicated for a singular blog post. But these are the basics to these complicated Exchanges. Take care when dealing in these, and it’s important to seek help from a tax professional and/or a legal expert when handling these exchanges.