1031 Exchange Basics

By Ben Gardiner, Broker Associate

This article regarding 1031 exchanges is for informational purposes only and is not intended as professional advice; always consult your qualified advisors before making business decisions.

We deal with 1031 exchanges quite frequently and receive many questions about them from Sellers and Buyers. Below is the definition, some of the basic rules, and how the process works.

A 1031 Exchange is an investment vehicle established by the IRS to “defer” capital gains that would be realized and taxed when an investment property is sold.

BASIC RULES:

• Swap must be for “like-kind” property (investment property for another investment property). Primary residential properties are not eligible. However, the rules are flexible –
  agricultural land is considered an investment property so it could be swapped for commercial properties, apartments, etc. (or vice-versa).
• Proceeds from the sale must be held in escrow by a third party (a 1031 intermediary), then used to purchase the new property. If you’ve already received funds from a sale,
  it’s too late to do a 1031 Exchange.
• Two key timing rules must be observed – the first being the 45-day identification window. Potential replacement properties must be identified during this time period, in
  writing, to the 1031 intermediary. The next is the 180-day rule. You must be CLOSED on any potential replacement properties within 180 days of the sale of the old property.
• Reverse-Exchange: the process is done in “reverse.” This means that you would buy the property you want, then sell the property you currently own. The same timing rules
  apply. It is more costly upfront with higher fees but may alleviate the risk of not finding a replacement property within the designated time frame.
• There are rules about how long you must own the property before you are eligible for an exchange.

It is essential to know your potential tax liability when selling a property – this can help determine if a 1031 Exchange is right for you. Often the tax basis is a factor in this decision. Your tax professional should help you determine your tax basis in the land that you are considering selling. Most often, this will be the price that was paid for the land. However, if you inherited the land, you are likely currently eligible for a step-up in tax basis.

A step-up in tax basis example is as follows: if your property was purchased by your parents in 1985 and then you inherited the property upon their death in 2010, your tax basis
would be the market value of the property in 2010 – not the price paid in 1985. On the contrary, if you were deeded the land from your parents without any consideration paid (did
not receive the land upon their death), then the original 1985 tax basis remains and capital gains tax would apply to any appreciation from 1985 to the current date of sale.

Once the amount of capital gain is determined, the percentage of capital gains tax can vary depending upon your individual tax bracket and state that you live in. In all situations, if you are considering a 1031 Exchange, be sure to consult with a 1031 intermediary and your tax professional to determine eligibility, potential tax savings and possible issues. The IRS has some basic tips on Like-Kind Real Estate Exchanges on their website.

This article was originally published in our Fall 2022 Newsletter.