What is a 1031 Exchange?

Melissa N. Osika, MBA

If you want to add investment real estate to your diversified portfolio, you're going to want to know what a 1031 Exchange is. While the rules and regulations for this tactic can get complicated, understanding the basic concepts will help you decide if this strategy is right for you.

Let's look at what a 1031 Exchange is and some of the requirements to help you determine if you should pursue this avenue further for your long-term investment goals.

What is a 1031 Exchange?

In the simplest terms, a 1031 Exchange is a real estate investment strategy that allows you to defer your capital gains taxes on an investment property if you sell it and buy another "like-kind" property. According to the IRS, "if you make a like-kind exchange, you are not required to recognize a gain or loss under Internal Revenue Code Section 1031."^1,2

1031 Exchange Requirements

While a 1031 Exchange can be a great strategy for deferring capital gains taxes, there are some requirements to consider to ensure that both properties are eligible. Here are a few of the main requirements:

• The property you sell must have been used as an investment property, not as your primary residence. The IRS defines a property as a primary residence "if it's used for personal purposes during the tax year for more than the greater of 14 days or 10 percent of the total days rented to others at a fair rental value."³
• Because a 1031 Exchange is considered a swap, you need to designate the second property shortly after the sale of the first property. According to the IRS, "you have 45 days from the date you sell the relinquished property to identify potential replacement properties."⁴
• In addition to this 45 day rule, you must also close on the new property within 180 days.
• Lastly, funds from the 1031 Exchange must be held in an escrow account, and you can't receive them personally.⁵

Who is a 1031 Exchange Good For?

As you can see, there are a lot of specifics to consider when researching 1031 Exchanges. For this reason, they aren't right for everyone. But they are suitable for select investors, and in such cases, they have many benefits.

Mainly, 1031 Exchanges are good for people who are looking to add investment real estate to their portfolios, especially those who already have investment property. If you already have an investment property and want to swap it for another property without paying capital gains taxes, talk to a CPA or financial advisor to make sure you get the specifics correct.

Another great benefit of 1031 Exchanges is that, if you pass away without selling a property obtained through a 1031 Exchange, your heirs won't be expected to pay capital gains taxes on the property. In addition, they will inherit it at its stepped-up market rate value.⁶

To summarize, the main benefits of a 1031 Exchange are:

• You can defer paying capital gains taxes on an investment property if you “swap” it for another investment property.
• You can use a 1031 Exchange as a powerful estate planning tool.
• You can continue to generate income from an investment property while also building tax-deferred equity in the property.

A 1031 Exchange is just one vehicle in a well-diversified financial strategy and something to consider for investors interested in growing their investment real estate portfolios.

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