1031 Exchange Simplified
A 1031 exchange (also known as the like-kind exchange) is simply swapping one real property (or real estate) for another. In effect, you can change the form of your investment without cashing out or recognizing a capital gain. That allows your investment to continue to grow tax deferred.
One exception to this applies when a depreciable property is exchanged. It can trigger a profit known as depreciation recapture, which is taxed as ordinary income. In general, if you swap one building for another building you can avoid this recapture. But if, for example, you exchange improved land with a building for unimproved land without a building, the depreciation you've previously claimed on the building will be recaptured as ordinary income.
Another exception is when cash and debt are involved. If you have cash left over after the intermediary acquires the replacement property (referred to as “boot”), the intermediary will pay it to you at the end of the 180 days. That boot will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain. You must also consider mortgage loans or other debt on the property you relinquish, and any debt on the replacement property. If you don't receive cash back but your liability goes down—that, too, will be treated as income to you, just like cash.
Keys to a 1031 Exchange
• There needs to be a qualified intermediary (middleman), who holds the cash after you "sell" your property and uses it to "buy" the replacement property for you.
• Two VERY important timing rules, which run concurrently and starts from the date your old property was sold.
• Within 45 days of the sale of your property, you must designate the replacement property in writing to the intermediary, specifying the property you want to acquire. You can designate three properties so long as you eventually close on one of them.
• You must close on the new property within 180 days of the sale of the old property.
• If you want to use the property you swapped for as your new second or even primary home, you can't move in right away. The IRS set forth a safe harbor rule, under which it said it would not challenge whether a replacement dwelling qualified as an investment property for purposes of Section 1031. To meet that safe harbor, in each of the two 12-month periods immediately after the exchange:
• You must rent the dwelling unit to another person for a fair rental for 14 days or more.
• Your own personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
• If you acquire property in a 1031 exchange and later attempt to sell that property as your principal residence, the primary residence capital gains exclusion will not apply during the five-year period beginning with the date the property was acquired in the 1031 like-kind exchange.