Basic Rules for a 1031 Exchange

Usually, when you sell an investment, capital gains taxes apply to any profit you make. But a so-called 1031 exchange allows you to dispose of an investment property without paying capital gains taxes, as long as you reinvest the proceeds of the sale in another investment according to specific rules. If you're an investor considering a 1031 exchange, make sure you understand these rules, since breaking them could leave you on the hook for thousands of dollars in taxes.

Like-Kind Exchanges

The term "1031 exchange" is a reference to Internal Revenue Code Section 1031, which defines such exchanges. The tax code and the IRS itself actually use the term like-kind exchange. That's because to qualify for the special tax treatment of a 1031 exchange, the property you are getting rid of and the property you are acquiring must be of "like kind," or similar in "nature, character or class."

Real estate usually is considered of like kind to other real estate. The rules for personal property -- tangible objects such as vehicles, gold bars or rare stamps -- are far more restrictive. Cars are of like kind with other cars, for example, but not with trucks,. Computers would be of like kind to other computer equipment, but not to vehicles. A professional tax advisor can help you determine whether items of personal property are of like kind. However, real estate and personal property are never of like kind with each other, according to the IRS.

Certain Investments Barred

Some types of property are specifically prohibited from being used in a 1031 exchange. These include:

  • Inventory or any other goods that are bought for resale, rather than as an investment.
  • Securities, such as stocks, bonds or derivatives.
  • Debt, such as the right to collect payments on mortgages or loans.
  • Partnership interest in a business.
  • Beneficial interest in a trust.
  • The right to file a lawsuit against a particular party, also known as a chose in action.

So, for instance, you couldn't sell stock at a profit and then avoid capital gains taxes by buying more stock and calling it a 1031 exchange.

Simultaneous — or Nearly So

In a 1031 exchange, you're not simply selling one property and buying another. Instead, for tax purposes, you are exchanging one piece of property for another. In the simplest kind of 1031 exchange, you'd have a piece of property you don't want, you'd find someone with a like-kind property you do want, and the two of you would swap properties. Such situations are rare, however. You can also perform a deferred exchange, in which you sell your property now and buy a like-kind property later as part of a single deal. According to the IRS, most people performing deferred exchanges go through an exchange facilitator — a middleman who connects people who have properties they want to exchange.

When you perform a deferred exchange, time limits apply. After you sell the original property, you have 45 days to identify the like-kind property and 180 days to complete the purchase, or your entire profit on the sale becomes taxable. These are strict deadlines, too. The only way they can be extended is if you live in a president-declared disaster area.

Tax Effects of the Exchange

A 1031 exchange doesn't eliminate capital gains taxes. It simply pushes capital gains taxes into the future. Usually, when you sell an investment, you're taxed on your capital gain — the money you received from the sale minus your basis in the investment. In general terms, your basis in an asset is what you paid for it, plus any costs you paid to improve it. In a 1031 exchange, your basis from your original investment transfers to the new one. You'll be subject capital gains tax when you sell the new investment — unless you perform yet another 1031 exchange.