What Is a 1031 Exchange?

Knowing the 1031 exchange rules helps you save on taxes.

Real estate investing is a choice investment option for many people. According to a 2017 survey by RealtyShares, only 15 percent of Americans are investing in real estate other than their main residence, but 77 percent of respondents age 35 to 44 and 72 percent of respondents age 18 to 34 believe house flipping is a good investment.

If you’re interested in growing your own real estate empire, minimizing your taxes helps you maximize your income. Using a 1031 tax-deferred exchange to trade old properties for new ones can help you do just that. Here’s what you need to know about a 1031 exchange.

Taxes on Selling Rental Properties

During your time owning a rental property, you can claim deductions each year for depreciation. However, when you sell your property, you pay taxes on both the amount of depreciation taken over the years and the increase in the value of the property since you bought it. This can limit how much of the sale proceeds you can reinvest in a new property. For example, if you bought a property for $100,000, claimed $30,000 in interest deductions, and then sold the property for $140,000, you would have to pay taxes on the $30,000 of depreciation recapture and $40,000 in capital gains.

Read: How to (Legally) Cheat Your Tax Bracket

Like-Kind Exchange Requirements

A 1031 exchange, named after the section of the tax code allowing it, permits you to exchange one investment property for another of a like-kind, generally without having to pay taxes on your gains or depreciation recapture. Like-kind properties refer to assets of the same nature or character, even if they have a different quality. For example, real estate properties of any kind within the U.S. are generally considered like-kind.

See: The Best and Worst Cities to Own Investment Property

How a 1031 Exchange Works

The 1031 exchange requirements necessitate that you exchange a current investment property for a new investment property. It doesn’t have to be a straight-up trade between you and one other party. Instead, you can sell your current property and, using a qualified intermediary to hold the money, then identify potential replacement properties within 45 days and complete the exchange within 180 days. In a reverse 1031 exchange, you use an intermediary to purchase a replacement property first, and then within 180 days, you sell your existing property.

Ineligible Property

If you receive non-like-kind property as part of the purchase price, you must include that portion of the proceeds as taxable income to you. For example, if you exchange one rental for another rental and $100,000 cash, you would have to recognize gains on that $100,000 received. In addition, beginning in 2018, most types of like-kind exchanges that aren’t real estate, such as machinery, equipment, cars, artwork and other collectibles, generally do not qualify to be part of a 1031 exchange. For example, you can’t exchange a Renoir for a Picasso and avoid paying taxes on the gains.

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