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A 1031 exchange can postpone taxes on gains from qualifying real estate when an investor exchanges one property for another that meets the like-kind rules. The transaction can preserve more capital for another investment, but the deferred gain may become taxable later. Investors also have to satisfy specific IRS requirements and report the transaction correctly to receive tax-deferred treatment.
A financial advisor may be able to help you with a long-term strategy leveraging 1031 exchanges to keep growing your investment real estate portfolio.
1031 Exchange Essentials
Internal Revenue Code Section 1031 allows investors to defer gain when exchanging qualifying real property. Since 2018, Section 1031 has applied only to real property held for business or investment purposes, not personal or intangible property. Property held primarily for sale also does not qualify.
The relinquished and replacement properties must be like-kind, but that requirement is broad for real estate. Properties generally qualify when they are of the same nature or character, even if they differ in quality or use. For example, improved and unimproved real estate can generally be like-kind. However, U.S. real property is not like-kind to real estate located outside the United States.
Exchanges can take different forms. In a basic simultaneous swap, an investor trades one property for another directly. Another option, a deferred exchange, allows the investor to transfer the old property before subsequently acquiring one or more replacement properties.
Reverse exchanges start with acquiring the new property before disposing of the old one. Deferred exchanges commonly involve a qualified intermediary so the investor does not take actual or constructive receipt of the sale proceeds before they are used to acquire the replacement property.
Reporting a 1031 Exchange
A qualifying exchange still has to appear on the investor’s federal tax return even when the transaction produces no immediately taxable gain. The exchange is reported for the year in which the investor transfers the relinquished property.
For a deferred exchange, the investor generally gets 45 days after transferring the old property to designate possible replacements. Acquisition of the new property must generally occur no later than 180 days after that transfer or before the applicable tax return deadline, taking extensions into account, if that date arrives sooner. Failing to meet either time limit can prevent the gain from receiving Section 1031 deferral.
Investors can also pursue partial exchanges involving cash or other property that isn’t like-kind, often called boot. Receiving boot does not necessarily disqualify the entire exchange, but gain generally must be recognized to the extent of the money or fair market value of other non-like-kind property received. A loss generally cannot be recognized in a qualifying exchange.
If an exchange extends into the following calendar year, the tax-filing deadline requires particular attention. An investor who needs additional time to complete the exchange may have to extend the tax return so the filing deadline does not shorten the available exchange period.
1031 Exchange Forms
Taxpayers report exchanges on Form 8824, Like-Kind Exchanges, attaching it to their returns. The form asks for:
- Descriptions of properties sold and purchased
- Key dates, including when the relinquished property was transferred and when the replacement property was identified and received
- Information about related parties involved in the exchange
- Value and basis details for the properties
- Calculations for realized and recognized gain
Form 8824 is required even when the entire gain is deferred. Depending on the transaction, investors may also need Form 4797, Sales of Business Property, Form 8949, Sales and Other Dispositions of Capital Assets, or Schedule D, Capital Gains and Losses.
If taxable gain results from an exchange involving business or depreciable property, Form 4797 may be required. Schedule D may also apply depending on the character of the recognized gain.
Choosing the Right Forms
Form 8824 documents the like-kind exchange, while other tax forms may be necessary based on what the transaction includes. Recognized gain involving business property, for example, may need to be entered on Form 4797. Certain capital gains can require Schedule D and an installment obligation received in an exchange can bring Form 6252 into the filing.
These forms establish the amount of gain taxable for the current year and the amount carried forward through the replacement property.
Taxes are deferred, not necessarily eliminated. In general, the replacement property’s basis reflects the basis carried over from the relinquished property, with adjustments for money or other property transferred or received and gain recognized. That lower carryover basis preserves the deferred gain for potential taxation when the replacement property is eventually disposed of in a taxable transaction.
How to Calculate the Basis of the Replacement Property
Calculating the replacement property’s basis is an important part of reporting a 1031 exchange because basis affects future depreciation deductions and the gain or loss calculated when the new property is eventually sold.
In a fully deferred exchange, the replacement property generally takes a basis derived from the adjusted basis of the relinquished property rather than simply starting with the replacement property’s purchase price or fair market value. This is how the deferred gain carries forward into the new investment.
For example, assume an investor exchanges real estate with an adjusted basis of $300,000 for qualifying replacement property worth $500,000 and contributes an additional $200,000 in cash. The investor’s basis in the replacement property would generally be $500,000, consisting of the $300,000 carried-over basis plus the additional $200,000 paid.
The calculation becomes more complicated when the investor receives cash or other non-like-kind property, transfers property subject to debt or assumes liabilities on the replacement property. Form 8824 incorporates these amounts when calculating recognized gain and the basis of the replacement property. Accurate basis records should be retained because the figures can affect depreciation and taxes years after the exchange occurs.
Related-Party 1031 Exchanges
Exchanging property with a related party brings additional requirements. The rules can cover transactions involving certain relatives as well as businesses, partnerships, trusts and other entities connected through specified ownership relationships.
A later sale or other disposition of property from a related-party exchange can affect the original tax treatment when it occurs during the two-year holding period. Exceptions apply in certain circumstances, so the later transaction does not automatically cause recognition of the earlier deferred gain or loss.
Related-party exchanges can also create additional Form 8824 filing obligations after the initial transaction. Investors should maintain records showing the parties involved, exchange dates and any subsequent disposition of the properties.
Bottom Line
Reporting a 1031 exchange involves documenting the properties, transaction dates, basis and any gain taxable in the current year. Form 8824 is used to report the exchange, while Form 4797, Schedule D or Form 6252 may also apply depending on the transaction. Section 1031 generally postpones rather than eliminates tax on qualifying gains, with the deferred amount carried into the basis of the replacement property and potentially affecting taxes when it is later sold in a taxable transaction. Keeping complete records can provide the information needed for future depreciation and gain calculations.
Tax Planning Tips
- Given the intricate tax rules for 1031 exchanges, consider meeting with a financial advisor to ensure you are complying fully. As well as making best use of the tax deferral benefits when investing in real estate. SmartAsset’s free tool matches you with vetted financial advisors who serve your area. You can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s income tax calculator to estimate your obligation or refund for this year.
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