Suppose you bought a rental property in Cuyahoga County years ago and it has gone up in value. If you sell it outright, part of what you planned to reinvest goes to taxes. A 1031 exchange, named for Section 1031 of the Internal Revenue Code, lets investors put off that tax by rolling the value into another investment property. It is one of the most useful tools in real estate, but it runs on strict rules and short deadlines, and most of the mistakes can’t be fixed later. Here is a plain-English overview.
What a 1031 exchange does
Normally, selling investment real estate at a profit triggers tax on the gain. In a qualifying exchange, you dispose of one property (the “relinquished” property) and acquire another (the “replacement” property) without recognizing gain at that time, to the extent the rules are met.
The key word is deferral. The IRS describes these exchanges as tax-deferred, not tax-free. The basis of the old property generally carries over to the new one, with adjustments, so the deferred gain stays built into the replacement property. It generally becomes taxable when you later sell in a transaction that isn’t another exchange. A properly structured exchange generally defers Ohio income tax along with federal tax, but it is worth confirming the state and local treatment for your own facts, especially if property is located outside Ohio.
What qualifies, and what doesn’t
Since 2018, Section 1031 has applied only to real property. Equipment, vehicles and other personal property no longer qualify. Both the property you give up and the property you receive must be held for productive use in a trade or business or for investment.
“Like-kind” is broader than many people expect. It refers to the nature of the property, not its quality or use, so most U.S. real estate is like-kind to other U.S. real estate. Vacant land can generally be exchanged for a rental building, for example. Several things fall outside the rules, though:
- Your personal residence. A home used solely as a residence doesn’t qualify, although the separate home sale exclusion in Section 121 may apply.
- Property held primarily for sale. Inventory, such as houses bought to fix and flip, generally doesn’t qualify.
- Foreign real estate paired with U.S. real estate. The two aren’t like-kind to each other.
- Entity interests. Stock, bonds, notes, partnership interests and trust interests aren’t real property for this purpose. Selling your interest in an LLC taxed as a partnership is generally different from the LLC exchanging the property it owns.
Vacation homes are a gray area. The IRS has generally treated property held mainly for personal use as ineligible, but Revenue Procedure 2008-16 offers a safe harbor for certain dwellings. Among other things, you must own the property for at least two years before or after the exchange (depending on whether it is the relinquished or replacement property), rent it at fair value for at least 14 days in each of those years, and keep personal use within set limits.
The two deadlines that control everything
Most exchanges are “deferred” exchanges, meaning you sell first and buy later. Two clocks start on the day you transfer the relinquished property, and they run at the same time:
- 45 days to identify. You must identify replacement property in a signed, written document by midnight on the 45th day. The description must be clear, such as a street address or legal description, and the document must go to the seller of the replacement property or another person involved in the exchange who isn’t disqualified. Property you actually acquire within the 45 days counts as identified.
- 180 days to close. You must receive the replacement property by the earlier of the 180th day or the due date of your tax return for the year of the transfer, including extensions.
If a sale closes on March 1, for example, the 45th day is April 15 and the 180th day is August 28. Note the tax return trap: if you sell late in the year, your return may come due before day 180, which can shorten the exchange period unless you extend the return.
How many properties can you identify?
The regulations limit how many properties you can name. You generally must satisfy one of these rules:
- Three-property rule: up to three properties of any value.
- 200 percent rule: any number of properties, as long as their combined value doesn’t exceed 200 percent of the value of the property you gave up.
- 95 percent rule: if you go over those limits, the identification still works only if you actually acquire identified property worth at least 95 percent of the total value of everything you identified.
Why you need a qualified intermediary
The fastest way to ruin an exchange is to get your hands on the money. If you receive the sale proceeds, or have the right to them, before you complete the exchange, the transaction can be treated as a taxable sale. That includes funds credited to your account or otherwise made available to you.
To avoid that result, most investors use a qualified intermediary. Under a written exchange agreement, the intermediary holds the proceeds and the agreement limits your access to them until the exchange is finished. You can’t serve as your own intermediary, and neither can a “disqualified person.” With limited exceptions, that includes someone who has acted as your employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the prior two years, as well as certain related parties.
Choose carefully. Intermediaries are holding your money, and the IRS has warned that some have gone bankrupt. Ask about how funds are held and safeguarded before you sign. And bring in the intermediary before your sale closes, because the arrangement generally must be in place at that point.
Cash and debt relief can create taxable “boot”
An exchange doesn’t have to be all or nothing, but anything you receive that isn’t like-kind property is called “boot,” and it can trigger taxable gain up to the amount of the boot. Boot includes cash, other non-qualifying property and net debt relief, such as when the mortgage you pay off is larger than the debt you take on.
For that reason, investors seeking full deferral commonly try to buy replacement property of equal or greater value, reinvest all of their net proceeds, and replace any paid-off debt with new debt or additional cash. If you sell for $500,000 and buy for $480,000, for example, the $20,000 difference may be taxable, depending on your gain and other facts.
Other common pitfalls
- Changing the taxpayer. Generally, the taxpayer that sells must be the taxpayer that buys. A single-member LLC disregarded for tax purposes is typically treated as its owner, but changing the owner or entity mid-exchange can create problems, so raise any planned restructuring early.
- Related-party deals. Exchanges with family members or related entities face special rules. If either side disposes of the property within two years, the deferred gain generally becomes taxable, subject to limited exceptions.
- Quick resales or conversions. The statute doesn’t set a specific minimum holding period, but intent matters. Buying a property and immediately selling it or moving into it can undercut the claim that it was held for investment.
- Forgetting the paperwork. Exchanges are reported on IRS Form 8824 with your return for the year of the transfer. Related-party exchanges also require the form for the following two years.
Getting started
If an exchange might fit your plans, the best time to start is before you list the property, and at the latest before you sign the closing documents. A practical first step list:
- Ask your tax adviser to estimate your gain and compare the tax cost of a sale with the value of deferring it.
- Confirm that the property qualifies and that the same taxpayer will be on both sides of the transaction.
- Line up a qualified intermediary and put the exchange agreement in place before closing.
- Start scouting replacement properties early, since 45 days passes quickly, and add exchange cooperation language to your purchase and sale contracts.
- Put the 45-day and 180-day dates on your calendar the day you close, and check them against your tax return due date.
Vincent Esquire helps Ohio property owners and investors with real estate transactions, contracts and closings, and can work alongside your tax adviser and intermediary. Learn more about our real estate law services or reach out to talk through your situation.
This article is for general informational purposes only and is not legal advice. Reading it does not create an attorney-client relationship. Laws change and every situation is different, so consult an attorney about your specific circumstances. Attorney advertising.
