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If you’re thinking of selling a piece of property that could result in a big profit (and a big tax bill), a 1031 exchange could be a useful strategy.
What is a 1031 exchange?
A 1031 exchange, named after section 1031 of the U.S. Internal Revenue Code, is a way to postpone capital gains tax on the sale of a business or investment property by using the proceeds to buy a similar ("like-kind") property.
What qualifies as a 1031 exchange?
A key rule about 1031 exchanges is that they’re generally only for business or investment properties. Property for personal use — like your home, or a vacation house — typically doesn’t count. Securities and financial instruments, such as stocks, bonds, debt instruments, partnership interests, inventory and certificates of trust aren’t usually eligible for 1031 exchanges.
» MORE: Read how capital gains tax works on home sales.
How to do a 1031 exchange
A 1031 exchange can be complex, so you'll likely want to consult with a qualified tax pro. You can read the rules and details in IRS Publication 544, but here are some basics about how a 1031 exchange works and the steps involved.
Important things to know about 1031 exchanges
Here are some of the notable rules, qualifications and requirements for like-kind exchanges.
You still have to pay tax, just later. A 1031 exchange doesn’t make capital gains tax go away; it just postpones it. A capital gains tax bill will come due at some point, so prepare for that.
The properties don’t have to be as similar as you may think. You don’t necessarily have to swap a rental property for an identical rental property or a parking lot for a parking lot. "Like-kind" generally means you’re swapping one investment property for another investment property (again, be sure to see a qualified tax pro before taking action). It might be possible to exchange vacant land for a commercial building, for example.
Relationships matter. Your qualified intermediary or exchange facilitator can’t be a relative, your attorney, banker, employee, accountant or real estate agent. People who have served you in any of those capacities in the past two years are also off-limits. And you can’t be your own qualified intermediary.
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Types of 1031 exchanges
Here are three kinds of 1031 exchanges to know.
In a simultaneous exchange, the buyer and the seller exchange properties at the same time.
Deferred exchange (or delayed exchange)
In a deferred exchange, the buyer and the seller exchange properties at different times. However, the sale of one property and the purchase of the other property have to be "mutually dependent parts of an integrated transaction." The rules here can get particularly complex, so see a tax pro.
In a reverse exchange, you buy the new property before you sell the old property. Sometimes this involves an "exchange accommodation titleholder" who holds the new property for no more than 180 days while the sale of the old property takes place. Again, the rules are complex, so see a tax pro.
Watch out for 1031 exchange scams
The IRS permits 1031 exchanges. But someone promoting them might have ulterior motives if they tell you to exchange vacation homes (property for personal use typically doesn’t qualify) or that the deal is tax-free (actually, it’s tax-deferred).