What are 1031 Tax Deferred Exchanges & How Do They Work?

1031 Defined: In a “1031 exchange” (A.K.A. like kind exchange), an asset – real estate – is sold and the proceeds from that sale are then reinvested in another real estate asset.

Via this exchange, the individual will not recognize any immediate losses or gains as per Section 1031 of the Internal Revenue Code. The associated capital gains taxes are deferred until the exchange property is sold and not exchanged. Should the subsequent resale of this property go into another exchange, then the losses or gains would be deferred again, and this process can continue indefinitely.

§ The exchange property (the one you are buying) must be identified within 45 days.

§ All proceeds of the initial sale must be re-invested in the exchange property within 180 days (not 6 months) of that sale.

§ When exchanging real property, you must do so with “like kind” real property. In other words, real estate has to be exchanged for real estate.

§ All proceeds from the sale of an exchanged property must be placed in escrow with a Qualified Intermediary (QIs are usually title attorneys), who will execute the 1031 exchange on your behalf.

§ 1031 Exchanges can only take place with investment property, commercial property, or trade property (no personal residences).

§ Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.

1031 Exchange Example:

An investor decides to sell a four-plex in Alabama for $200,000 that was purchased 5 years ago for $100,000. The investor then “exchanges” the $200,000 for another investment property — say an overnight rental cabin in Gatlinburg— via a 1031 exchange. The investor will not have to pay any capital gains taxes or recapture any depreciation on the exchanged four-plex after the sale. All funds must be received and disbursed by the investors Qualified Intermediary (QI). The investor cannot “touch” any proceeds from the exchanged sale or it becomes a taxable event.