6 Rules to Understanding Section 1031 Exchange

Many business owners and individuals lose money in taxes simply because they are not aware of the Section 1031 Exchange.

You get to pay nothing in taxes on a resulting gain if the property exchange qualifies under Sec 1031.

To understand Section 1031 Exchange here are the rules:-

Rule # 1:

Only business or investment property can be exchanged for a similar property. For example one rental property for another, a completed building for an undeveloped farmland.

Rule # 2:

  • Follow the 45-day and the 180-day deadline. 
  • The property must be identified in writing within 45 days after the date of transfer of the relinquished property. 
  • The replacement property must be received by the 180th day after the day the property was given up or the due date, including extensions of the tax return for the year in which the transfer of that property occurs, whichever is earlier.

Rule # 3:

A qualified intermediary must be used to facilitate the transaction. It’s not a DIY project.

Rule # 4:

Both the transferred and the relinquished properties have to be local which means within the United States. You cannot exchange domestic property for a foreign one.

Rule # 5:

Say two rental properties are exchanged by Mr. A and Mrs. B. A’s property is more valuable than B’s. So B agrees to exchange her property and agrees to pay $10,000 in cash. Therefore, Mr. A must recognize the $10,000 of gain he realizes on the transaction, even if Sec 10361 tax deferral otherwise applies. 

Rule # 6:

Like-kind exchanges are allowed between related parties, including between family members. However, if either party disposes of the property within 2 years, then the gain or the loss on the original Section 1031 exchange becomes taxable.

File form 8824 with the tax return for the year of the exchange.

Useful Tips:

  • An inventory does not qualify for a Section 1031 Exchange. 
  • Personal property exchange also does not qualify. e.g. One personal residence for another personal residence does not qualify. 
  • The exchange of cash for property is termed as a sale, not as an exchange. 
  • Related parties are defined as close family members, two entities in which the same taxpayer owns directly or indirectly more than 50% of each, etc. 


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