What’s a 1031 Exchange?

Congress and the IRS allow real estate owners to defer capital gains through Section 1031 exchanges. If one piece of real estate is exchanged for another, then the adjusted basis of the first piece of real estate can be transferred to the newly-purchased property. For example: a condo bought in 1987 for $150,000 in Oakland’s Rockridge neighborhood is rented until 2022, when the owner sells for it $800,000 and immediately buys a ranch near Santa Fe, NM for $2 million. If certain (very strict) parameters are met, that owner can defer the 20% tax on the $650,000 worth of capital gains on the sale of the Oakland condo until the Santa Fe ranch is sold, sometime in the future. Without the Section 1031 exchange, the IRS will take $130,000 in capital gains tax on the Oakland condo sale.

This hypothetical transaction, and all other 1031 exchanges, must be planned in advance. If the condo’s already been sold, then it’s too late to enter into, or qualify for, a Section 1031 exchange. That’s because real estate must be exchanged for real estate, not for cash.  If the seller receives cash, even for a day, then the 1031 won’t apply.

What are the Main Rules of 1031 Exchanges?

An industry of 1031 exchange facilitators exists to handle these transactions and ensure they meet these stringent requirements:

  • The seller cannot directly receive the sales proceeds
  • Both properties must be owned for business purposes. Usually they are rentals. Sometimes they are office space owned by an individual or a corporation
  • The seller must identify, in writing, the replacement property within 45 days of selling the original property (“relinquished property” in IRS jargon). Sellers are allowed to identify up to three potential replacement properties
  • The purchase of the replacement property must be completed within 180 days of the sale of the original property

These deadlines are very strict, although there are rare occasions when Congress extends the deadline, such as for wildfires in California and in 2020 for Covid.

What Else Should I Know about 1031 Exchanges?

Once the sales proceeds have gone to the exchange facilitator, the seller has no control over the proceeds, except to direct them to the purchase of a new property. If the purchase transaction breaks down, the exchange facilitator must still hold onto the proceeds for the full 180 days.

1031 Exchanges usually involve mortgages. Sometimes the sale transaction results in “boot,” cash or other proceeds that go to the seller. To compute the actual amount of deferred gain, you will need to compute the adjusted basis in both properties, the difference in how much money is owed on the mortgage after the sale transaction, and the amount of boot.

These transactions get very complicated, and require advance planning. I recommend finding a good facilitator as soon as you think about selling. If the IRS questions whether a transaction fit into the requirements after the fact, I can help, but not if the bulleted requirements above have not been met.

October 12, 2022

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