How 1031 Exchange Works

A 1031 exchange is a way to avoid paying capital gains taxes on profits from property sales. New tax rules have changed some of the criteria for 1031 exchanges. Here’s what property sellers need to know about new IRS requirements for 1031 exchanges.

A 1031 Exchange Defers Capital Gains and Losses

According to Section 1031 of the United States Internal Revenue Service’s tax code, you can defer gains or losses on a property sale by reinvesting the proceeds of the sale in a like-kind property. This type of reinvestment, or property exchange is nicknamed a 1031 exchange.

An example of a simple 1031 exchange is a person selling one apartment building and then using the sales funds to purchase another apartment building. The newly purchased apartment building is considered a like-kind property, because the old property was the same type of structure as the newly bought property. The apartment seller can defer the taxes on the profit they gained from the sale of the old apartment building by purchasing the new apartment building. Had the person purchased an office building or residential home with the apartment-building-sale proceeds, they could not take advantage of the 1031 exchange rules.

Like-Kind Property Doesn’t Have to Be Exactly the Same

Under the like-kind rules, the old and new properties in a 1031 exchange don’t need to be exactly the same. For example, if you sell an upscale retail strip mall and then purchase a run-down, degraded strip mall, the properties qualify for the 1031 exchange. The poor condition of the new property is not an issue for the IRS as long as the exchange properties are the same types of real estate.

There are some interesting exceptions. If you sell an apartment building and then purchase unimproved land, both properties are considered like-kind.

New Tax Laws Change Eligible 1031-Exchange Property

The 2017 Tax Cuts and Jobs Act changed the requirements for 1031 exchanges. In the past, taxpayers could claim exchanges on personal and intangible property including:

  • Machinery
  • Equipment
  • Artwork and collectibles
  • Patents
  • Vehicles

Under the new rules, personal and intangible property do not qualify for the 1031 exchange treatment. Only real property can be considered for like-kind exchanges. However, there is a 1031 transition rule that allows you to exchange personal and intangible properties that you sold or replaced on or before December 31, 2017

Property Outside of the U.S. Does Not Qualify

Even if you purchase the exact same type of condominium complex in France that you just sold in Hawaii, you’re not eligible for capital gain or loss deferments. Property purchased outside of the U.S. is not considered like-kind compared to property sold within the U.S. and does not qualify for a 1031 exchange.

IRS 1031 Exchanges Require Expert Advice

The IRS rules regarding 1031 exchanges are complicated and strict. You must file a Form 8824 to report any property exchanges you made using the 1031 treatment. Hire a competent tax attorney or accountant to advise you before you set up any 1031 property exchange.