1031 exchange is the give and take of an investment property for another that makes capital gains taxes to be deferred. There are rules for this though. In 2021, the rules have been made more clear after the Tax Cuts and Jobs Act (TCJA) of 2017.
Table of Contents
- 1031 Exchange Changed Rules
- Current 1031 Exchange Rules
- Frequently Asked Questions About 1031 Exchange
- 1031 Exchange Fact Sheet PDF
Before you get to swapping one investment property for another, the rules must be known. As a general rule, an exchange can only be made with similar properties. The IRS also rules limit the use of vacation properties and there are deadlines and tax implications even though the purpose of a 1031 exchange is to defer the capital gains taxes.
IRS Changes to 1031 Exchange Rules
The Tax Cuts and Jobs Act of 2017 made plenty of changes to the U.S. tax code. The 1031 exchange rules weren’t untouched. Prior to 2018, it was possible to 1031 exchange a personal property such as an aircraft, equipment, franchise licenses, and other properties qualified for 1031 properties.
The TCJA’s biggest impact on the 1031 exchange was what kind of properties were qualified for a swap. From December 31, 2017 and beyond—including 2020 and 2021, only investment properties can be swapped under Section 1031.
The recent tax law change added a transition rule. This new 1031 exchange rule permitted the swap of qualified personal property in 2018 if the replacement property was acquired by December 31, 2017, or sold.
This rule is for certain taxpayers and doesn’t permit a reverse 1031 exchange in cases where the old property was sold before the new property was purchased.
Current 1031 Exchange Rules
While some of the 1031 exchange rules have been changed with the TCJA, some remain the same as it is.
First and foremost, a 1031 exchange isn’t something that you can do it yourself. You will need a middleman to keep the cash after you sell the property and buy the replacement property for you. If you were to keep the cash yourself, it would violate the 1031 exchange rules.
To get a better understanding of this, we would need to take a look at how 1031 exchanges happen. If you find a property that qualifies you to swap with another, that’s fine. Everything should go as smoothly as it can be. However, this isn’t the case for the most.
Most 1031 exchanges are delayed due to this. If the 1031 exchange is delayed, you will need a middleman—a qualified intermediary to hold the cash after you sell the property and keep it for you to buy the replacement property.
This comes with additional rules for a 1031 exchange:
If leftover cash is left after the sale of the replacement property, it will be returned back to you by the intermediary. This money will be taxed as it’s a partial sale’s proceeds from the sale of the old property. For example, if you sold your property for $500,000 and bought the new one for $490,000 under Section 1031, the leftover $10,000 will be taxed as a capital gain.
If you had a mortgage on the old property, there is one thing you need to know.
For example, if you had a $500,000 mortgage on the old property, but the mortgage on the replacement property you receive in exchange is $450,000. This is a $50,000 gain on your end and these kinds of gains are considered as boots and you will pay taxes on this gain.
First Timing Rule – 45 Days
After the 45 days of the sale of your property which should also be the same time as the intermediary receiving the cash, you must state the replacement property in writing to the intermediary. This also works as selecting the property you want to acquire. The IRS also allows more than one property to be designated.
Generally, you can designate up to three properties—even more as long as the valuation tests make the properties qualified.
Second Timing Rule – 180 Days
The second timing rule is simple. You certainly must close the new property 180 days after the sale of the old property. So, from the sale of the old property, you must close the new property.
Due to the coronavirus pandemic, the timing rule has changed. The Internal Revenue Service added an additional 45-day to the exchange deadline. So, instead of 180 days in total, you get 225 days to close off the replacement property.
1031 Exchange Frequently Asked Questions (FAQ)
1031 exchange as a whole can seem quite complicated. If you have any questions in your mind about 1031 exchanges, take a look at the most commonly asked questions about it.
Can a 1031 exchange happen without a qualified intermediary?
Yes. A qualified intermediary or QI or middleman is required to complete an IRC Section 1031. The QI will hold your money after the sale of the old property and use it to buy the new. During the swap, you can’t have access to your money. It would violate the 1031 exchange rules otherwise.
Who can be a qualified intermediary?
Anybody can be a qualified intermediary. Common examples of a qualified intermediary include real estate brokers or agents, attorneys, investment bankers or brokers, accountants, and people who work for the exchanger.
How much does a 1031 exchange cost?
The only 1031 exchange is the fee you will pay to the qualified intermediary. On average, expect to pay $500 to $1,500 for an exchange. This surely depends on what goes into the exchange and the amount the middleman holds until the exchange occurs.
Can a 1031 property be primary residence?
The federal law doesn’t allow 1031 exchange property to be your primary residence. This is due to what’s defined as a primary residence. Your primary residence is to provide shelter for you and your family. Since 1031 exchange properties are for investments, it can’t be used as a primary residence. If that were to happen, it won’t be a 1031 exchange after all.
What’s a 1031 exchange?
As simple as words can tell this a 1031 exchange is the swap of one property for another that defers capital gains taxes. The 1031 exchange under the IRC Section 1031 is only for investment properties only, not for primary residences.
IRC Section 1031 Fact Sheet PDF
The complete IRC Section 1031 is attached below. You can print out a paper copy or download it as a PDF to save it on your computer.