A 1031 exchange allows a taxpayer to exchange real property and defer gain or loss. If all the requirements of a 1031 exchange are met, gain or loss on the sale of old (relinquished) property is deferred until the new (replacement) property is later sold.
What is a 1031 exchange?
A 1031 exchange is a transaction in which eligible property is exchanged for property of like-kind and gain or loss is deferred for federal income tax purposes. Normally, when a taxpayer sells property, gain or loss on the sale is recognized in the tax year in which the sale occurs. But in a like-kind exchange, gain or loss on the sale of relinquished property is deferred until the replacement property is sold. A transaction qualifies as a 1031 exchange if it’s an exchange of eligible like-kind properties. Since the Tax Cuts and Jobs Act (TCJA), only real property qualifies for a 1031 exchange.
What type of real property qualifies for a 1031 exchange?
Property is eligible for a 1031 exchange only when it is considered real property under the laws of the state or local jurisdiction where the property is located at the time of the exchange. To qualify as a 1031 exchange, the exchanged properties must be held by the taxpayer for an eligible purpose.
Eligible purposes include:
- The 1031 exchange property must be held either for productive use in a trade or business or for investment.
- Land, and improvements to land, are property that qualifies for a 1031 exchange. The term improvements to land means inherently permanent structures like buildings and the structural components of inherently permanent structures such as walls, floors, and ceilings.
- Water and the air space over (“superjacent” to) land are eligible for a 1031 exchange (e.g., boat slips at a marina).
- Unsevered natural products of land can also qualify for a 1031 exchange. Unsevered natural products of land include things like growing crops and timber, mines, wells, and other natural deposits. Natural products like crops, timber, water, ores, and minerals will no longer qualify for a 1031 exchange once they’re severed or removed from the land.
The 1031 exchange regulations provide additional definitions and examples of qualifying real property.
What does not qualify for a 1031 exchange?
- A sale of property for cash.
- A sale of a property for cash and reinvestment of the proceeds like-kind property. In order to qualify as a 1031 exchange, the sale and purchase must be steps in an integrated plan, not independent transactions.
- Property such as inventory, which is held primarily for sale. The taxpayer’s primary residence and other property held for personal use is not eligible for a 1031 exchange.
- Stock, bonds, notes, other securities or evidence of indebtedness or interest.
- Interests in a partnership (other than a publicly traded partnership).
- Certificates of trust, certificates of beneficial interests, and choses in action.
Do intangible interests qualify for a 1031 exchange?
Only real property qualifies for a 1031 exchange, but some intangible interests are considered real property under Section 1031. Intangible interests that qualify for a 1031 exchange include:
- fee ownership
- a leasehold
- an option to acquire real property
- an easement
- stock in a cooperative housing corporation
- certain shares in a mutual ditch, reservoir, or irrigation company
When is property “like-kind”?
Property is like-kind based on the nature and character of the property. Real property is generally like-kind to other real property, regardless of whether it’s improved or unimproved. The IRS does not consider the grade or quality of the property when determining whether it’s like-kind.
Note: Real property located in the United States is not like-kind to real property located outside of the United States. The IRS published these useful real estate tips about like-kind exchanges.
What if a 1031 exchange includes like-kind property and boot?
If a 1031 exchange includes both like-kind property and “boot,” gain may still be partially deferred. Boot is any money or non-like-kind property received in the 1031 exchange. If a 1031 exchange includes boot, the taxpayer recognizes gain to the extent of the fair market value of the boot. Loss is still deferred even if the 1031 exchange involves boot.
What is a deferred exchange?
A deferred exchange is a 1031 exchange in which a taxpayer transfers property but does not receive the replacement property right away. A deferred exchange can still qualify as a 1031 exchange under several safe harbors that are available in the Internal Revenue Code.
For a deferred exchange, the replacement property must be identified within 45 days after selling the relinquished property. The deferred exchange needs to be fully completed within 180 days after selling the relinquished property. For example, if the relinquished property is sold on November 16, the 45-day identification period would end on December 31 and the 180-day exchange period would end on March 15 of the following year.
What is a reverse 1031 exchange?
A reverse 1031 exchange is when the taxpayer gets the replacement property before selling the relinquished property. Under the reverse 1031 exchange safe harbor, the taxpayer “parks” the replacement property with a third-party (the accommodation party) until the relinquished property is sold.
How is a 1031 exchange reported?
A 1031 exchange is reported on Form 8824 (Like-Kind Exchanges). The form is filed for the tax year in which the taxpayer transferred property to another party as part of the exchange. State reporting requirements may also apply.
Do all states allow 1031 exchanges?
Most states follow the federal income tax treatment of like-kind exchanges for state income tax purposes. Several states, including California, Oregon, Montana, and Massachusetts, provide special “claw-back provision” rules. Those states require that any gain in property value accrued in that state is subject to that state’s taxes – regardless of whether or not that property was exchanged in another state.
California, specifically, has a unique set of reporting rules on like-kind exchanges. Many states also levy real property transfer taxes on these transactions.
This information was last updated on 01/10/2022.
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