What is a 1031 Exchange?

A 1031 exchange(also called a like-kind or Starker exchange) is a swap of one real estate investment property for another that allows capital gains taxes to be deferred. Profits are transferred from one investment property to the next, thereby deferring taxes until you eventually sell the property for cash. An exchange can only be made with qualifying, like-kind properties as defined by IRS Section 1031. A principal residence usually does not qualify for 1031 treatment because you live in that home and do not hold it for investment purposes. A vacation home won’t qualify unless it is rented out and generates an income. There’s no limit on how frequently you can perform a 1031 exchange.

There are four kinds of 1031 exchanges: simultaneous, deferred, reverse, and improvement. The rules, tax implications, and time frames for each type can become particularly complex; consider consulting a tax professional for help or guidance.

An exchange involves a simple swap of one property for another between two people. The odds of finding someone with the exact property you want who also wants your property are slim. Therefore, most exchanges are deferred.

You need a qualified intermediary (middleman/exchange facilitator) who can’t be a relative, your attorney, banker, employee, accountant, or real estate agent. The intermediary holds the cash after you sell your property and uses it to buy the replacement property. You can’t accept the cash, or it will spoil the 1031 treatment.

Within 45 days of the sale of your property, you must designate the replacement property you wish to acquire in writing to the intermediary. You must close on the new property within 180 days of the sale of the old property. If there’s any cash left over after the exchange (known as “boot”), it will be taxable as a capital gain.

The exchange process can be complicated, so consider consulting a financial advisor and a tax professional to avoid any surprises on your tax return. You must notify the IRS of the 1031 exchange by compiling and submitting Form 8824 with your tax return in the year when the exchange occurred.