If your business sells real property (land or buildings) for a profit, the gains from each sale will be subject to a capital gains tax. If the property is a building, the depreciation you deducted on previous tax returns may be taxed as ordinary income. You can defer paying those taxes by using the proceeds of your sale to buy a replacement property in a 1031 property exchange.
A 1031 property exchange can be an effective tax-saving tool that enables a business to delay, not eliminate, taxes it would otherwise owe for the year it sold the property. To be eligible for the tax deferment, the business must comply with specific rules and timelines established by the IRS. This guide will cover the details of how to conduct a 1031 property exchange, as well as what to watch out for.
- A 1031 property exchange allows you to defer (not eliminate) taxes on capital gains and the accumulated depreciation.
- Properties generally qualify for a 1031 exchange if they’re used in a business or for investment. The properties being exchanged can differ in quality and be used for different purposes.
- You’ll qualify for a tax deferment only if you meet specific rules and timelines.
- The taxes are deferred until you eventually sell the property without making another exchange.
1031 Property Exchanges Explained
A 1031 property exchange is a type of “like-kind” exchange that’s permitted under Section 1031 of the U.S. tax code. The law allows businesses to sell real property and then postpone paying tax on the gain if they invest the proceeds in another similar property.
The simplest type of 1031 exchange involves a simultaneous swap of one property for another. Buying and selling properties at the same time isn’t always feasible, so the IRS permits deferred swaps in which you can sell a property, buy another one later, and still qualify for a 1031 exchange if you meet certain timelines.
A deferred property swap must be coordinated by a qualified intermediary (also called an exchange facilitator). You must designate an intermediary before you close on the sale of the property you’re relinquishing. Your intermediary will hold the proceeds of the sale and use the money to purchase a replacement property.
Property Requirements for a 1031 Exchange
For properties to qualify for a 1031 exchange, they must both be used in a trade or business or for investment. They must also be like-kind, and the IRS uses a broad interpretation of the term. Properties are generally considered like in kind if they’re similar in nature, character, or class (e.g., they’re both real estate). However, the properties don’t have to be of the same quality or used for the same purpose. For example, you can exchange an apartment building for a retail store or a warehouse for an office building.
Property you own for personal use, such as your primary residence or second home, doesn’t qualify for a 1031 exchange.
How To Make a 1031 Exchange
Suppose you’ve decided to sell a commercial building and you want to do a deferred property swap. Your first step is to choose a qualified intermediary, someone who has experience handling 1031 property exchanges and is not disqualified by IRS rules. Your intermediary cannot be the person who served as your agent at the time of the property sale. IRS rules also exclude anyone who acted as your employee, attorney, accountant, investment banker, broker, or real estate agent within two years of the transfer of the relinquished property.
To qualify for a 1031 exchange, you must follow two timelines:
- You must provide your intermediary with a description of your replacement property within 45 days of the sale of the relinquished property.
- You must close on the purchase of the replacement property within 180 days of the date of the initial sale or of the income tax due date for the year in which it occurred, whichever is earlier.
Special rules apply if the property you sell was financed with a mortgage and you use the proceeds of the sale to pay off that debt. The IRS requires you to replace the debt you paid off with cash or new debt on the replacement property. Otherwise, your payoff will be considered a gain and taxed as such. For example, suppose you sell a building and use the proceeds of the sale to pay off a $300,000 mortgage. The $300,000 will be taxed as a gain unless you replace it with cash or a mortgage on the replacement property.
Watch Out for Depreciation Recapture
When a business sells a building for a profit, the depreciation that has accumulated on the property is “recaptured” and treated as a gain. Recaptured depreciation is taxed as ordinary income, not long-term capital gains. Depreciation will be recaptured if one or both properties aren’t depreciable. For example, suppose you sell a warehouse for $1 million and immediately invest the proceeds in a piece of raw land, for which you pay $1.2 million. Land is not a depreciable asset under IRS rules. Consequently, all of the depreciation you claimed as a tax deduction while you owned the warehouse will be recaptured.
A 1031 property exchange could help you avoid depreciation recapture in some cases, but it’s complicated—which is why you should always seek professional help.
A 1031 Exchange Example
Here’s an example of how a 1031 exchange works.
Let’s say Bob bought a warehouse 10 years ago for $700,000. He has claimed $175,000 in accumulated depreciation. Bob’s adjusted basis is $525,000 ($700,000 - $175,000). When Bob sells the warehouse for $850,000, he realizes a taxable gain of $325,000 ($850,000 - $525,000). One month later, Bob buys an apartment building for $1 million. He invests the $850,000 from the sale of the warehouse and pays the remaining $150,000 from his savings.
Because Bob has exchanged the warehouse for an apartment building, he can defer the taxes he’d otherwise owe on his $325,000 capital gain. He can also defer the tax on the $175,000 in depreciation recapture.
The Bottom Line
A 1031 property exchange can be an effective tax-saving tool if your business buys and sells real property. You can defer capital gains taxes until you sell the replacement property without making another exchange. You’ll qualify for a tax deferral only if you meet the timelines and other requirements outlined in Section 1031 of the U.S. tax code.
Frequently Asked Questions (FAQs)
How many times can you do a 1031 exchange?
The IRS doesn’t limit the number of 1031 exchanges you do, so you can exchange one property for another as many times as you like.
When do you pay taxes on a 1031 exchange?
When you sell the replacement property without doing another exchange, you’ll pay tax on the original deferred gain, plus any additional gains realized since the purchase of the replacement property.