ARTICLE | February 20th, 2025

In the world of real estate, the Section 1031 exchange has been a significant tool for farmers, ranchers, and investors who want to grow their land base or real estate portfolio.

Introduction

A 1031 exchange enables a property owner to defer capital gains taxes on the sale of a property by investing the sale proceeds in a new property. By deferring the taxes, property owners have additional funds to invest in their new property and as such are able to accelerate the growth of their real estate portfolio. However, a 1031 exchange also has several parameters, rules and deadlines that need to be followed throughout the transaction’s process to qualify for the tax benefits. Let’s dig in to how a 1031 exchange works and look at some important considerations when using one.

Understanding Section 1031

A 1031 exchange takes its name from Section 1031 of the U.S. Internal Revenue Code which permits property owners to defer paying federal capital gains taxes after selling one property and purchasing another property within a certain amount of time.

Like-Kind Requirement and Property Types

When seeking a 1031 exchange, the IRS requires that the exchange be between like-kind properties, i.e., the two assets must be similar. In practice, a property owner can trade vacant land for a commercial building, or an industrial property can be exchanged for a retail property. However, you cannot swap real estate for cattle or equipment because that does not meet the like-kind requirement. Additionally, 1031 exchanges only apply to real estate.

Maximizing Tax Deferral

There are no limits to how many 1031 exchanges you can do and no cap to the amount of capital gain tax you can defer. However, you must roll all of the proceeds from a sale into new like-kindproperty in order to maximize the tax deferral.

Rules Governing Tax Deferral

Tax deferral is a substantial upside to a 1031 exchange, but it doesn’t come without some rules. First, unless a taxpayer is going to sell a property and purchase new property simultaneously, the sale proceeds will need to be held by a qualified third-party intermediary. If the taxpayer receives the sale proceeds directly, it will violate the 1031 exchange rules.

Designation and Acquisition Deadlines

Second, the taxpayer has 45 days from the date of sale to designate replacement property they intend to purchase. The taxpayer can designate up to three different proper- ties, and in certain circumstances more than three. But the taxpayer must only close on one property. Then, the taxpayer has 180 days from the date of sale to close on the acquisition of the replacement property. It’s important to note that it’s 180 days from the property sale and not 180 days from the date the taxpayer designated the replace- ment property.

Challenges and “Boot” in 1031 Exchanges

Finally, a common challenge for transactions that use 1031 exchanges is when a buyer transfers to a property or properties that in aggregate cost less than the property they sold. In these situations, the taxpayer is responsible for paying capital gains tax on the difference between the property they sold and the property they purchased. For example, if the taxpayer sells a property for $500,000 and subsequently purchases an asset for $450,000, they are liable for the capital gains tax on the $50,000 difference between the two. This is commonly known as “boot” in a 1031 exchange. Fortunately, boot can be avoided and minimized in several ways.

Exclusions and Special Cases

Aside from simply trading up for a higher-priced property, taxpayers can reinvest the excess funds into the new prop- erty by spending on renovations or maintenance related to the new property. Personal homes do not qualify for 1031 exchanges. However, the profits from selling your principal residence are generally tax-free as long as the increase in value from one home to the next one is less than $250,000 for individuals or $500,000 for married couples, as long as the taxpayer lived in the home for 2 or more of the previous 5 years. Special rules apply to using a 1031 exchange for vacation homes and second residence properties.

Guidance and Professional Support

If you are planning to sell a property and want to invest the proceeds into a new property, then a 1031 exchange may allow you to defer federal taxes on capital gains from the sale of the property. However, you will probably need the guidance of your attorney and accountant to ensure the transaction adheres to all IRS rules – even a small error could mean an unwelcome surprise on April 15th. If you are considering a 1031 exchange and want to discuss your unique situation, please contact our office. Our expert advisors are happy to help.

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