A Section 1031 like-kind exchange allows you to sell real property you own, purchase a like-kind property, and defer the capital gains tax on the sale of your original property. It only applies to real property held for business or investment purposes exchanged for real property held for business or investment purposes. Prior to 2018, personal and intangible property qualified for this special treatment as well. Since 2018, only real estate qualifies.
According to the IRS, properties are like-kind if they are of the same nature or character, regardless of their quality or grade. Real estate is typically like-kind, regardless of whether it is unimproved or improved. For example, you could sell an office building and purchase unimproved land while still qualifying as a like-kind exchange.
"Boot" is any non-like-kind property you receive in a like-kind exchange. If you receive boot—such as cash—as part of the exchange, you must recognize a gain and pay taxes on the money or other property received. Be aware, boot also applies to your mortgage loans. For example, assume you sold a property on which you had a $300,000 loan. If you purchase a new property where your loan is now only $200,000, you have a $100,000 gain.
Timing Rules for Like-Kind Exchanges
Like-kind exchanges are unlikely to occur as a straightforward swap of two properties. Because there is likely a delay in time between the sale of your original property and the purchase of the replacement property, you should take certain steps to ensure your property swap qualifies as a 1031 exchange.
A delayed exchange occurs when you sell your original property before acquiring your replacement property. If you have a delayed exchange, you cannot accept the cash from your first sale directly. Instead, you need a qualified intermediary—a third party who holds the cash from the sale of your original property. The qualified intermediary will then use the cash to purchase the replacement property for you.
You have two timing obligations to meet after the sale of your original property. First, you must identify the replacement property with written notice to a third party—such as your qualified intermediary or the potential seller of the replacement property—within 45 days. Second, you must close on the replacement property within 180 days.
There are three different options for identifying your replacement property:
- Three Property Rule. You can identify up to three properties of any value.
- 200% Rule. You can identify unlimited replacement properties, but the total of their values cannot exceed 200% of the relinquished property.
- 95% Rule. You can identify unlimited replacement properties, but you must acquire at least 95% of the total value of all the properties you identified.
A reverse exchange occurs when you acquire your replacement property before selling your original property. If you have a reverse exchange, you will need an exchange accommodation title holder to hold the replacement property until you sell your original property. After the sale of your original property, the exchange accommodation title holder can transfer the title of the replacement property into your name.
Other Rules for Like-Kind Exchanges
Real estate located within the US can only be replaced by property located within the US. For example, you can't sell a rental in Seattle and purchase a rental in Cancun under the like-kind exchange rules.
Property held primarily for resale does not qualify for a like-kind exchange. This means you cannot purchase a property with the intention to fix it up and flip it and expect to purchase another property while deferring taxes on the first. However, if you held the property for business or investment purposes, it can qualify for this beneficial tax treatment.
You can meet this requirement if you rent the property out before selling it. If you were planning to flip a property, look into renting it before or after fixing it up if you want to benefit from a Section 1031 like-kind exchange. The tax consequences are significant.
Section 1031 Exchange Form
To report an exchange of business or investment real estate for like-kind property, you should complete Form 8824, Like-Kind Exchanges.