Everything You Need to Know About a 1031 Exchange

Introduction to 1031 Exchanges

For decades, real estate investors have used strategies like the 1031 Exchange to defer paying capital gains taxes on high-value assets. Other tax deferral methods include SDIRAs, qualified opportunity funds, tax-loss harvesting, and primary residence exclusions. However, the 1031 Exchange, governed by IRS Code Section 1031, is particularly popular among real estate investors.

Understanding Capital Gains

Capital Gains: The increase in the value of an asset over time, taxed upon sale.
Short-term vs. Long-term: Short-term gains (assets held <1 year) are taxed as ordinary income, while long-term gains (assets held >1 year) are taxed at 0%, 15%, or 20%, depending on the tax bracket.

How to Defer Capital Gains Tax

Several methods allow real estate investors to defer capital gains taxes:

• SDIRAs: Own real estate within a retirement account to defer taxes until withdrawal.
• Qualified Opportunity Funds: Invest in economically depressed areas with tax incentives.
• Tax-loss Harvesting: Offset gains with losses to reduce net taxable profit.
• Primary Residence Exclusion: Exclude up to $250,000 ($500,000 for joint filers) of gain from the sale of a primary residence.
• 1031 Exchanges: Exchange investment properties to defer taxes indefinitely.

What is a 1031 Exchange?

A 1031 Exchange, also known as a “like-kind exchange,” allows property owners to sell an investment property and use the proceeds to buy another investment property, deferring capital gains taxes. The new property must be of equal or greater value.

Current Rules:

• Timing: Identify replacement property within 45 days and complete the purchase within 180 days.
• Qualifying Properties: Both properties must be for business or investment purposes.
• Vacation Homes: Must be rented out for at least 14 days per year for two years before and after the exchange to qualify.

Potential Changes to 1031 Exchanges

The Biden Administration’s FY 2024 budget proposes capping deferrals at $500,000 per taxpayer, potentially impacting many investors. Additionally, the administration seeks to raise the top capital gains tax rate from 20% to 39.6%.

The Bottom Line

While proposed changes to the Internal Revenue Code may affect the future of 1031 Exchanges, investors can still utilize this strategy to defer capital gains taxes on like-kind property exchanges.

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