1031 exchanges and deferring real estate gains

In short

If you are holding a rental property that has grown in value, you have probably felt the sting of thinking about the tax bill on a sale. A 1031 exchange lets an owner swap one investment property for another and put off the tax on the gain. The word is defer, not erase. The tax comes due later, unless the rules for a later swap or other planning change the picture. The owner must hire a qualified intermediary before the sale closes, because the owner cannot touch the sale money. Two clocks start the day the old property sells, and missing either one ends the deferral. Talk with a tax professional before you sign a contract, since one small slip can undo the whole thing.

The whole of it

What it is

A friend of mine sold a duplex some years back and was shocked at what he owed. He had treated the profit like it was all his, and the tax return said otherwise. I understood the feeling, and I think most of us would have felt the same way.

A 1031 exchange gets its name from Section 1031 of the Internal Revenue Code. It lets a person who owns real estate for business or investment trade it for other real estate of the same kind and put off paying tax on the gain. Think of it as continuing the same investment in a new form, rather than cashing out. The law treats it that way, and so the tax is not due at the swap.

Two points matter right away. The property must be held for business or investment, so a home you live in does not qualify. And since the Tax Cuts and Jobs Act of 2017, the rule covers real property only. A swap of equipment, vehicles, or art no longer qualifies under Section 1031. Real property can mean land, rentals, shops, and farms, and the tax rules call all of these like kind when swapped for each other. A rental house can trade for raw land. An office can trade for an apartment building. The kind is about the nature of the holding, not the look of the building.

How it works

I once watched a neighbor try to do an exchange by himself, and he got most of it right and still lost the deferral. He took the sale check home first. That one step ended it.

Here is the usual path. The owner signs a sale contract for the old property, which the tax rules call the relinquished property. Before closing, the owner hires a qualified intermediary, sometimes called an exchange accommodator. This is a neutral third party who holds the sale money. The buyer pays the intermediary, not the owner. If the owner receives or controls the cash, the exchange fails. The intermediary then uses the money to buy the new property, called the replacement property, for the owner.

Two deadlines apply, and the IRS counts them in calendar days with no pause for weekends or holidays. The first is 45 days from the sale of the old property. By then, the owner must name the possible replacement properties in writing, signed, and sent to the intermediary. The second is 180 days from the sale, or the due date of the tax return for that year, whichever comes first. By then, the owner must close on the replacement. Both clocks begin on the same day. They do not stack.

Any cash left over that the owner takes out is called boot. Boot is taxed in the year of the exchange. Debt can count too. If the new property carries less debt than the old one and the owner does not add cash to make up the gap, the difference can be treated as boot as well. To defer all the gain, the owner generally buys a replacement of equal or greater value and uses all the proceeds.

The numbers, and where to find yours

The tax at stake depends on a few figures from your own records. The first is the adjusted basis, which is what the owner paid for the property, plus the cost of improvements, minus the depreciation taken over the years. The second is the sale price, less selling costs. The gap between them is the gain.

Part of that gain may be taxed at a special rate. Depreciation that the owner claimed is taxed under a rule called unrecaptured Section 1250 gain, with a top rate set by law at the current figure, which the official source publishes each year. The rest of a long term gain is taxed at the capital gains rates, which are the current figure, which the official source publishes each year. High earners may also owe the net investment income tax of the current figure, which the official source publishes each year. The site shows the current figures with their source and date.

You can find your numbers in a few places. Your closing statement from the purchase shows what was paid. Your past tax returns, especially Form 4562 and the depreciation schedules, show what was claimed. The exchange itself is reported on IRS Form 8824, and the form's instructions on the IRS website walk through each line. The IRS also publishes Publication 544, called Sales and Other Dispositions of Assets, which covers like kind exchanges.

A worked example

Let me tell you about a woman named Dolores, who owned a small rental house in Ohio. She bought it years ago for $180,000. Over time she spent $20,000 on a new roof and a kitchen, and she claimed $60,000 in depreciation. Her adjusted basis is $180,000 plus $20,000 minus $60,000, which is $140,000.

She sells the house for $350,000 and pays $20,000 in selling costs. Her net sale price is $350,000 minus $20,000, which is $330,000. Her gain is $330,000 minus $140,000, which is $190,000.

Without an exchange, that $190,000 would be taxed in the year of the sale. Of it, $60,000 is the depreciation she claimed, and $130,000 is the rest. Each part is taxed at its own rate, and the exact rates depend on her income that year.

Now suppose Dolores uses a qualified intermediary. The buyer's $330,000 goes to the intermediary. Within 45 days, she names a small apartment building in writing. Within 180 days, she closes on it for $400,000. She uses all $330,000 of proceeds plus $70,000 of new money and a new loan to cover the price. Because the new property costs more than the old one sold for, and she used all the cash, she has no boot.

Her gain is deferred, not gone. Her basis in the new building carries over. It is her old basis of $140,000 plus the extra $70,000 of cash she added, which is $210,000. That number matters later, because a lower basis means a bigger gain when she finally sells for cash.

Suppose instead she had taken $30,000 out. That $30,000 is boot, and she would owe tax on it in the year of the swap, since it is less than her $190,000 gain. A small amount, but real.

Where it goes wrong

I have heard more than one sad story at the end of a hard year, and most of them have a missed date in the middle. The 45 day and 180 day clocks do not bend. If the owner names the replacement on day 46, the exchange fails. If the closing happens on day 181, same result.

Touching the money is the other common trap. The seller must not receive the sale proceeds, not even for a day. The intermediary must be arranged before closing, since a late hire cannot fix a check already cashed. Choosing the intermediary is worth care. The person who does your exchange should not be your own agent, lawyer, or accountant from the past two years, under the Treasury rules.

Some owners forget about boot. Taking cash, or paying down less debt, can trigger tax they did not plan for. Others overlook the title. The same taxpayer who sold the old property generally must be the one who buys the new one. A sale by one person and a purchase by that person's company can raise trouble.

Also, the rules do not cover a vacation home used mostly for fun, or a home flipped for quick profit. Property held mainly for resale, as dealers hold inventory, does not qualify. Related party swaps carry their own holding period rules under the Code. And a deferral can turn into a permanent change only if the owner follows other tax rules, such as the step up in basis at death, which a tax professional can explain. Be careful. State tax rules can differ from federal ones, so check yours.

Questions to answer before you leave this page

Is the property you own held for business or investment, rather than as your home? Do you know your adjusted basis, and have you found your old depreciation schedules and closing papers? Have you picked a qualified intermediary, and have you done it before the sale contract closes? Can you list possible replacement properties within 45 days, and can you close on one within 180 days? Will the new property cost at least as much as the old one sold for, so no boot is created? Have you asked a tax professional how your state treats the exchange? And what is your plan for the deferred gain, since the tax is only waiting, not gone?