Navigating 1031 Exchange to Not Have To Pay Taxes

man hanging sold sign in front of house.
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Selling real estate for more than you paid for it is a good thing, but the capital gain has tax consequences. If you used the property for business or held it as an investment, you can defer the tax by trading the property for one similar in terms of use. This type of transaction is known as a 1031 exchange, and you can use it to defer taxes indefinitely — with full approval from the IRS.

Read: What To Do If You Owe Back Taxes to the IRS

What Is a 1031 Exchange?

A 1031 exchange, also called a like-kind exchange, is a real estate transaction where you trade a passive-income-generating property — a business-use property or one held as an investment property — for a “like kind” property.

The sale and purchase are treated as a single transaction carried out by a qualified intermediary appointed by the exchanger.

When properly executed, a 1031 exchange allows an investor to defer capital gain tax on the profit from the sale of the relinquished property. That’s because they don’t realize the gain — it goes directly into the purchase of the replacement property.

Who Can Benefit From a 1031 Exchange?

Any commercial or investment property owner who trades one property for another property of equal or greater value — and who will sell the relinquished property for more than they invested in it — can benefit from a 1031 exchange.

Vacation rental owners are a good example. If you start with a one-bedroom vacation rental and earn year-round rental income from it for several years while it appreciates, you can trade up to a three-bedroom unit that’ll generate even more rental income. If you follow the rules governing 1031 exchanges, you can defer paying capital gains tax on the one-bedroom unit. And you can do it whether you own the property as an individual or business entity.

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There are some conditions, however:

  • You must have had the property in service for business use or held it as an investment property — flips aren’t eligible.
  • The same individual or entity that owns the relinquished property must purchase the replacement property.
  • You must identify the replacement property by notifying a qualified intermediary in writing within 45 days of the sale of the relinquished property. The intermediary handles the any money that changes hands as part of the exchange and executes the transaction.
  • The purchase of the replacement property generally must be complete within 180 days after the qualified intermediary is notified.

How Does a 1031 Exchange Work?

Understanding how a 1031 exchange works is key to abiding by the rules and ensuring that your transaction is eligible. An error could cause you to be disqualified from deferring your capital gains tax.

Here’s a simplified description of the steps you take to do the exchange:

  1. Determine the basis, which is your capital investment, in the property you’re going to relinquish. The basis is usually the original cost, less the value of the land, plus improvements less depreciation, though there are exceptions.
  2. Get the home appraised.
  3. Find one or more like-kind replacement properties for the property you intend to relinquish. Generally speaking, a commercial property can be exchanged for a rental property, and vice versa.
  4. Appoint an intermediary to handle the transactions and reporting. The intermediary can be anyone other than a family member, employee or legal or financial representative, including your real estate agent. There is an exception to the latter, however; your agent must not have worked with you in the last two years and the exchange is an even one resulting in no gain or loss.
  5. Complete the sale of the relinquished property. The intermediary will deposit the sale proceeds into an escrow account.
  6. Close on the sale of the replacement property. The intermediary will pay for the replacement property from escrow account.
  7. Report the exchange to the IRS at tax time.
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Rules for Identifying Replacement Properties

You have three options for identifying replacement properties:

  • Identifiy up to three properties.
  • Identify more than three properties with a combined value of not more than 200% of the value of the relinquished property.
  • Identify more than three properties with a combined value of more than 200% of the value of the relinquished property, and acquire at least 95% of the combined value.

Valuations are tricky — always work with tax and real estate professionals on replacement property identification.

Can a Vacation Home Qualify for a 1031 Exchange?

A vacation home might qualify for a 1031 exchange, but only if you’ve rented it out, even if only as a short-term vacation rental, and your own use has been very limited. The IRS considers the relinquished second home to’ve been “held for productive use in a trade or business or for investment” if:

  • The taxpayer has owned it for at least the 24 months before the exchange
  • Within each of the two 12-month periods prior to the exchange, the taxpayer rented out the property at fair market value for at least 14 days
  • Within each of the two 12-month periods prior to the exchange, the taxpayer’s own use did not exceed the greater of 14 days or 10% of the number of days the property was rented at fair value

The replacement property must meet the same standards, but for the two years following the exchange. All other rules surrounding a 1031 exchange apply.

Alternative Capital Gains Avoidance for Vacation Homes and Your Primary Residence

A 1031 exchange isn’t the only way to avoid capital gains tax on the sale of a vacation home, but you’ll have to plan way ahead to take advantage of the alternative. The IRS exempts up to $250,000 in capital gains ($500,000 for married couples filing jointly) from the sale of a primary home — “primary” being the operative word. To take advantage of this exclusion, you must live in the home as your primary residence for at least two years of the five years immediately preceding the sale, but you don’t have to roll the money into another home.

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Also, the two years don’t have to be consecutive years. You can live in the house one year and rent it the next, as long as it’s your primary residence for two years. Or you can create your own 1031 of sorts even if you don’t rent out your second home — just alternate which home you live in for five years, and then exclude $250,000 in capital gains tax on the sale of each. Although you can only take one exclusion every two years, there’s no limit on how many times you can exercise the exclusion.

Before You Start a 1031 Exchange

Remember that a 1031 exchange is a strategy for deferring capital gains tax. It’s not a strategy for avoiding it, although it can have that effect if you never sell the replacement property except in another exchange. However, a mistake can lead to a significant and unexpected tax liability, especially if you’re exchanging a home you lived in or will live in during part of the five years before or after the exchange. Because there’s so much room for error, it’s important to seek the advice of a tax professional before you start an exchange.

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