Stax Logo
Stax Short Logo
Stax Logo

What are the 1031 Exchange rules?

Written by sbm

June 02, 2020

Investing in real estate is one of the best ways to diversify your portfolio. That said, you have to know how to navigate the world of real estate investment to make appropriate investment decisions.

A familiar term for real estate investors is a 1031 exchange, a handy tax tool allowing you to change the form of your real estate investment without losing the original property's tax-deferred status.

That said, in order for such a transaction to be considered valid, you have to abide by strict 1031 exchange rules. Here's a look at how the rules work for such an exchange and a few special cases that you might encounter as an investor.

What Is a 1031 Exchange?

A 1031 exchange, named for the Internal Revenue Code Section 1031, is a provision of the tax code allowing investors to defer paying federal capital gains taxes on business or investment properties and some exchanges of real estate.

This is thanks to the Starker Loophole or like-kind exchange.

Let's say you have an investment property that has been growing in a tax-deferred state, so you don't need to pay capital gains taxes on it. If you wanted to sell that investment property and replace it with a new one, most such swaps are taxable.

However, if your exchange meets the criteria of a 1031 exchange, you'll have limited or no tax at the time of the exchange and the replacement property can continue to grow in a tax-deferred state.

The Basics of 1031 Exchange Rules

In order to qualify for a 1031 exchange, the replacement property must be "like-kind" which is a rather vague legal term. According to the IRS, properties are like-kind if they are of the same nature or character, even if they are of differing quality or grade.

Under this logic, an apartment building is considered like-kind to another apartment building. However, a house inside the U.S. is not considered like-kind to a similar house outside the U.S.

As long as you comply with 1031 exchange guidelines, the property sale will qualify for tax deferral and all taxes will be deferred. If the exchange does not comply with 1031 exchange guidelines such as 45 day identification rules, your property loses its tax-deferred status and taxes come due in the current tax year.

Updated Rules (The Tax Cuts and Jobs Act)

The passage of the 2017 Tax Cuts and Jobs Act changed the rules slightly for 1031 exchanges.

Under the Act, personal or intangible property such as machinery, equipment, artwork, patents, collectibles, and intellectual property do not qualify for nonrecognition of gain or loss as like-kind exchanges. Only real property may be used for this purpose, i.e. real estate and the buildings and land attached to it.

Special Rules

Beyond the basics of 1031 exchanges, there are certain rules applying to unique cases.

For example, special rules apply to depreciable property, i.e. any property eligible for tax and accounting purposes to book depreciation under the Internal Revenue Code. This includes things like:

  • Real estate (except land)
  • Vehicles
  • Computers
  • Office equipment
  • Heavy machinery

 

If a depreciable property is exchanged, it can trigger a profit called depreciation recapture which is taxed as ordinary income.

Here are a few other unique 1031 exchange rules to watch for.

Delayed Exchanges and Timing

Under the classic 1031 exchange, two people agree to swap properties. No fuss and feathers. Simple, right?

Not quite.

The odds of finding someone who wants to exchange a highly similar property with you can be quite slim. For this reason, most 1031 exchanges are technically delayed or Starker exchanges.

In these cases, you need a qualified intermediary who holds the proceeds for you after you sell your investment property and then uses those proceeds to buy the new investment property on your behalf. This is viewed as a regular swap, but it has two timing rules: the 45-day rule and the 180-day rule.

45-Day Rule vs. 180-Day Rule

The 45-day rule applies first and kicks in as soon as you sell your original property.

Once the property is sold, the proceeds must go to your intermediary. If the money passes to your hands, it will spoil the exchange. In addition, under the 45-day rule, you have to designate a replacement property within 45 days of the original sale.

This must be performed in writing to your intermediary, specifying the property you plan to acquire. You are not obligated to close within 45 days. You can designate up to three potential properties. As long as you close on one of them, the replacement property will remain tax-deferred.

However, you are obligated to close on one of the properties within 180 days, thus the 180-day rule. If you fail to close on one of the replacement properties within that window, your new property loses its tax-deferred status.

Navigating Your Property Investment

Knowing your way around 1031 exchange rules opens up a new world of real estate investment possibilities for savvy investors. That said, you have to know what you're doing before you try to embark on a 1031 exchange--otherwise, you may find yourself facing steep taxes you weren't prepared for.

That's where we can help.

We know that investment can often feel like a maze. We also know it doesn't have to. We put financial freedom first by helping you discover potentially suitable investment opportunities with lower minimum investments and totally passive management.

Sound like the right fit for your investment needs? If so, get in touch today to learn more.

Related articles

Real Estate Investing

Firm up your portfolio Stax Capital offers Direct Participation Programs including Delaware State Trusts, Opportunistic & Value Add Funds, Real Estate Development and Qualified Opportunity Zone Funds to accredited investors. Potential to: Add diversification - Real estate investing is not directly correlated to traditional investments like stocks and bonds. Real estate has historically minimized exposure […]
Learn More

Passive real estate investments – What to Know

Passive real estate investments may be an attention-grabber for investors who believe that the real estate market can be a lucrative investment platform, especially those who do not wish to be actively involved in the day-to-day running activities associated with managing real estate properties. This is not surprising because, although investing in real estate may […]
Learn More

Qualified Opportunity Funds (QOFs): 2021 Update

One year after a global lockdown triggered by the COVID-19 outbreak, the United States federal government has continued to be supportive towards stimulating the economy through aids for eligible businesses, schools and towards vaccine production and distribution. The pandemic has kept a lot of investors on their toes due to an increase in market volatility. […]
Learn More
1 2 3 7

DISCLOSURE

This website is for informational purposes only. This website does not provide investment advice or recommendations, nor is it an offer or solicitation of any kind to buy or sell any investment products. Securities offered through Stax Capital, Member FINRA & SIPC. Stax Capital is located at 7960 Entrada Lazanja, San Diego, CA 92127. Contact us toll free at 844-427-1031. Private Placements and Direct Participation Programs are speculative investments and involve a high degree of risk. An investor could lose all or a substantial portion of his/her investment. Investors must have the financial ability, sophistication/experience and willingness to bear the risks of an investment in Private Placements and Direct Participation Programs. Private Placements and Direct Participation Program offering materials are not reviewed or approved by federal or state regulators. Investors should not place undue reliance on hypothetical or pro forma performance summaries. Investors must conduct their own due diligence and should rely on the advice of their own financial, tax and legal advisors prior to making any investment decisions.

The contents of this website are neither an offer to sell nor a solicitation of an offer to buy any security which can only be made by prospectus. Investing in real estate and 1031 exchange replacement properties may not be suitable for all investors and may involve significant risks. These risks include, but are not limited to, lack of liquidity, limited transferability, conflicts of interest and real estate fluctuations based upon a number of factors, which may include changes in interest rates, laws, operating expenses, insurance costs and tenant turnover. Investors should also understand all fees associated with a particular investment and how those fees could affect the overall performance of the investment. Neither Stax Capital nor any of its representatives provide tax or legal advice, as such advice can only be provided by a qualified tax or legal professional, who all investors should consult prior to making any investment decision. Pursuant to SEC rule 501 of Regulation D, prior to engaging in substantive discussions regarding DST specific investments, investors must first be qualified as an accredited investor, by way of meeting certain income or net worth requirements.

Past performance is not an indication of future returns.

This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of Stax Capital or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.

There are substantial risks in the DST Investment program. This type of investment is speculative, is illiquid, and carries a high degree of risk – including the potential loss of the entire investment. See the “risk factors” in the Private Placement Memorandum for a complete discussion of the risks relevant to DST offerings. Investors have no control over management of the Trust or the property. There is no guarantee that investors will receive any return. Distributions may be derived from sources other than earnings. The property will be subject to a Master Lease with an Affiliate of the Sponsor. The property will be subject to the risks generally associated with the acquisition, ownership and operation of real estate including, without limitation, environmental concerns, competition, occupancy, easements and restrictions and other real estate related risks. The properties may be leveraged. The Manager, the Master Tenant and their Affiliates will receive substantial compensation in connection with the Offering and in connection with the ongoing management and operation of the property. The Manager, the Trust, the Master Tenant and their Affiliates will be subject to certain conflicts of interest. An investment in the Interests involves certain tax risks.

chevron-down