The 1031 exchange, or like-kind exchange (LKE), is a useful tool for real estate investors to defer taxes that they would have otherwise incurred when selling their investment home.

The idea is this: instead of selling your investment home and incurring capital gains and depreciation recapture taxes, you exchange your home for another, and the taxes are deferred until you finally sell the new home, or an even later exchanged home.

Freeing investors to invest

This is something that savvy real estate investors have taken advantage of since it entered the Internal Revenue Code in 1921, and the Government created this form of tax deferral for a couple of reasons:

1) The Government wanted to avoid unfair taxation – in an exchange, there is a change in the form but not the substance of your relative economic position. This means you do not have the means or the wherewithal to pay the taxes on any realized gain.

2) The Government wanted to encourage domestic investment (foreign homes do not qualify for the LKE – more on qualifying homes later). 

The 1031 exchange emerged, then, as a resolution for those who might feel “locked-in” to owning homes that they wanted to sell, but were unable or unwilling to due to the tax hit they would receive, as well as those who wanted to “trade-up” their homes for something larger or newer. 

What homes qualify

The like-kind exchange is now limited to domestic real estate used in a trade or business or held for investment, and the homes of all parties in the exchange need to qualify. Primary homes do not qualify, nor do cars, trucks, or financial instruments – stocks, bonds, cryptocurrencies, etc. Bad news for everyone else, but good news for real estate investors. 

Exactly what taxes are deferred

When you sell your investment home, you will be hit with either a short- or long-term capital gains tax, as well as a depreciation recapture tax. The 1031 exchange will defer all these taxes until you finally sell the new home, or an even later exchanged home. It is important to remember: a deferred tax is a minimized tax due to the time value of money, and the deferred taxes can be invested or used to grow your trade or business. 

How many times and how often can I do an LKE

There is no limit to how many times you can do a 1031 exchange, but the question “how often” does not have as clear of an answer. The Internal Revenue Code does not explicitly say how long you must hold your home before you can exchange it – it is only said that it must be held for investment purposes. The IRS has advised that you hold your new home for at least two years, but time is only one factor in determining taxpayer intent. Consult your tax professional. 

What are the logistics of the exchange

The like-kind exchange does not have to take place simultaneously. A delayed exchange can occur while one party decides what home they want to receive for their old home. In the case of a delayed exchange, a qualified intermediary is required. The qualified intermediary facilitates the exchange and must be a nonrelated 3rd party (it cannot be an agent, broker, accountant, lawyer, banker, etc. who has provided you tax, legal, accounting, or financial services in the last 2 years). 

There are also strict timelines that must be adhered to when doing a delayed exchange. 

The new property must be identified within 45 days of the date the old property was transferred to the qualified intermediary. The identification must be in writing, signed, and given to either the other party in the exchange or your qualified intermediary. 

And, the new property must be received by the earlier of the following: 

• within 180 days of the date the old property was transferred to the qualified intermediary, or
• the due date (including extensions) for the tax return covering the year of transfer 

Just like it is difficult to orchestrate a simultaneous exchange, it is also difficult to orchestrate an exchange in which both homes are the same price. The party with the lesser valued home can give “boot,” which can be either property or cash, to make up for the difference. 

So that’s it? 

Almost. Your home’s cost basis will also change when you do a 1031 exchange. Your qualified intermediary or tax professional will calculate this for you, but it’s good to be able to get a sense of it yourself. The formula is: 

   Fair market value of asset received
– Any deferred gain
+ Any deferred loss
= Basis of like-kind property received

This formula gets more complicated when “boot” is involved, but like I said, your qualified intermediary or tax preparer can calculate it for you.

Lastly, the holding period of your old home will get tacked on to the holding period of your new home. 

Here’s how Tania Wu Real Estate & Investment Team can help

The 1031 exchange is a great way to reinvest into a new home and defer your taxes, but it can be a complex process. The Tania Wu Real Estate & Investment Team helps guide you through the process and work with our trusted attorneys to ensure that the timeline and process go smoothly.