The Basics of a "1031 Exchange".

A 1031 exchange is simply an exchange of one investment property for another, where the capital gains taxes on the property sold are deferred. The strategy is named after the section in the IRS tax code, section 1031. A 1031 Exchange is a very popular and commonly used strategy in buying and selling investment properties. Investors can defer the capital gains taxes to a future period where it may be more advantageous to pay them.

An investor considering using a 1031 Exchange should engage a 1031 Exchange agent and their CPA early in the process. There are very specific timelines and requirements that need to be met for the exchange to be successful. A miss on a timeline or property detail could void the exchange or result in a sponsor's tax event.

This article will touch briefly on two of the main requirements for a successful 1031 exchange: timeline and debt replacement.

There are two main periods in a 1031 Exchange. The first is the 45 day period where you must identify three potential properties to exchange for and notify your exchange intermediary of those properties. The intermediary will receive the cash from your property's sale and hold onto that cash throughout the exchange process. If the cash from the sale goes to the sponsor, the exchange is void.

The second timeline is within 180 days after the sale of your property, and you must close on purchasing one of the properties you had previously identified to your intermediary. It's important to note that both time periods run concurrently. If the sponsor takes the full 45 days to identify replacement properties, they will have fewer days to close on the property they ultimately choose.

Debt replacement is often an area where investors find themselves in a taxable event. If there is any mortgage debt on the property being sold, that debt needs to be "replaced" on the new property. If the debt is lower on the new property, the difference will be counted as cash to you and could be taxable. For example: if you sell a property with a $1M mortgage balance on it and only have a loan of $700k on your new property, the difference of $300k is considered cash to you and could be taxable.

This article intended to quickly highlight a few key parts of a 1031 Exchange. Any investors looking at utilizing this strategy should engage a qualified exchange agent and their CPA for further advice on the process.