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What is a 1031 Exchange and How Does It Work?

By December 5, 2022Land

A 1031 exchange is a tax-deferral strategy used in real estate investing. It allows investors to sell a property, reinvest the proceeds into a “like-kind” property, and defer paying capital gains taxes on the sale. Technically, this type of exchange is called a “like-kind exchange,” but it’s more commonly known as a 1031 exchange after the relevant section of the tax code.

Types of Properties Eligible for 1031 Exchanges
In order to qualify for a 1031 exchange, the property being sold must be “like-kind” to the property being purchased. The IRS has interpreted “like-kind” very broadly to include all types of investment property, including:,
-Single-family rental homes
-Duplexes and other small multifamily properties
-Commercial office buildings and retail centers
-Industrial warehouses and storage units
-Vacant land
Basically, any type of investment property can be exchanged for any other type of investment property. It should be noted, however, that property held for personal use—such as a primary residence or a vacation home—is not eligible for a 1031 exchange.

The Process of Completing a 1031 Exchange
There are four key steps to completing a 1031 exchange:
1. Identify potential replacement properties. You have 45 days from the date of selling your original property to identify one or more possible replacement properties. You can identify up to three properties without regard to value or any number of properties as long as their total fair market value does not exceed 200% of the fair market value of the property being sold.
2. Purchase the replacement property. The deadline for purchasing the replacement property is 180 days from the date you sold your original property or the due date (including extensions) of your tax return for that year—whichever comes first.

3.-Notify your Qualified Intermediary (QI). A QI is a third party who facilitates the 1031 exchange by holding onto the proceeds from the sale of your original property and then distributing those funds to purchase the replacement property according to your instructions. You must notify your QI of your intent to complete a 1031 exchange within 45 days of selling your original property.

4.-Complete all paperwork and file Form 8824 with your taxes. Within 120 days of selling your original property, you’ll need to prepare and submit Form 8824 with your federal tax return for that year. This form details all information related to your 1031 exchange, such as identification numbers for both properties involved in the swap and proof that you’ve met all deadlines associated with the process.

A 1031 exchange is an excellent way to defer paying capital gains taxes on an investment property sale—but it’s not without its challenges. From meeting strict deadlines to finding suitable replacement properties, there’s a lot that can go wrong if you’re not prepared. But if you do your research and work with experienced professionals, you can successfully complete a 1031 exchange and continue growing your real estate portfolio tax-free.