Listing remarks
- Since the Tax Cuts and Jobs Act, Section 1031 applies only to exchanges of real property, not personal or intangible property.
- In a deferred exchange, replacement property must be identified within 45 days and received within 180 days, or by the tax return due date if earlier.
- Real property in the United States is not like-kind to real property outside the United States.
Sooner or later, many rental owners want to sell one property and buy a bigger or better one. Normally the sale triggers tax on the gain, including the depreciation taken over the years. Section 1031 of the Internal Revenue Code offers a way to postpone that tax by exchanging the property for other like-kind property. The rules are strict, and the deadlines cannot be extended for convenience. This is a summary of how the IRS describes them; anyone planning an exchange should work with a qualified tax professional before the sale closes.
What qualifies
According to the IRS, a like-kind exchange is an exchange of real property used for business or held as an investment solely for other business or investment property of the same type. Under the Tax Cuts and Jobs Act, Section 1031 now applies only to real property, not to personal or intangible property.
- Both properties must be held for business or investment. Your personal home does not qualify, and property held primarily for sale, such as a house you are flipping, does not qualify either.
- Like-kind is broad for real estate. The IRS says real properties generally are of like kind whether improved or unimproved; an apartment building is generally like-kind to another apartment building.
- Location matters. Real property in the United States is not like-kind to real property outside the United States.
The two deadlines
Most exchanges today are deferred: you sell first and buy the replacement later. The IRS instructions for Form 8824 set two firm limits.
| Deadline | Rule |
|---|---|
| Identification | No later than 45 days after you transfer the property you give up, you must identify the replacement property in a signed written document delivered to the proper party, or in the written exchange agreement. |
| Receipt | You must receive the replacement property by the earlier of the 180th day after the transfer or the due date, including extensions, of your tax return for that year. |
Both clocks start on the same day, and they run at the same time: the 45 days are part of the 180, not added to them. Note the tax-return trap: if you sell late in the year, your return may be due before day 180 unless you file an extension.
Who holds the money
In a deferred exchange you should not take control of the sale proceeds. Exchanges commonly use an intermediary, and the IRS rules exclude “disqualified persons,” generally your agent at the time of the transaction or a person related to you, from certain roles. The details are in Treasury regulations, which is one more reason to set the exchange up with a professional before closing, not after.
Related parties
Special rules apply to exchanges with related parties, directly or indirectly. The IRS’s list of related parties includes your spouse, child, grandchild, parent, grandparent, brother or sister and related corporations, partnerships, trusts and estates. If either party disposes of the exchanged property within two years, the deferred gain can become taxable, with limited exceptions. Report these exchanges on Form 8824 in the year of the exchange and for the next two years.
Cash and other property: “boot”
If you receive cash or other property that is not like-kind in addition to the replacement property, you generally owe tax on the gain up to the value of that extra property. Exchanges that leave you with cash, or with less debt on the new property than on the old one, often produce some taxable gain.
Tip: Run the numbers both ways with your tax professional: the tax you would owe on a straight sale, and the deferred amount with an exchange. Deferral is valuable, but it also carries a lower basis into the new property.
Deferred, not forgiven
The gain you do not pay tax on carries over into the replacement property through its basis. The IRS explains that the basis of the property you receive is generally the basis of the property you gave up, adjusted for any money or other property involved. When you eventually sell the replacement in a taxable sale, the deferred gain, including depreciation that would have been recaptured, generally comes due. See Rental Property Taxes: Income, Deductions, Depreciation and Losses for how depreciation and recapture work.
Reporting
You report a like-kind exchange on Form 8824 with your tax return for the year in which you transferred the property you gave up. The form walks through the dates, the properties, any related party and the figures for gain deferred and gain recognized.
The bottom line
A 1031 exchange can let a rental owner trade up without an immediate tax bill, but only for investment real property, only within 45 and 180 days and only if the proceeds are handled correctly. Plan it before you list the property. If you are just starting out, it is one of the long-term advantages discussed in Real Estate Investing Pros and Cons: An Honest Look.