What is a 1031 Exchange? A Brief Guide
Do you know what a 1031 exchange is but don’t know where to start? Perhaps you don’t even have an idea about what a 1031 exchange is? Don’t worry! Here are some basic ins and outs of a 1031 exchange:
A 1031 tax exchange essentially allows an investor to sell a property and reinvest the proceeds in a new property without immediately paying taxes on their capital gains. The technical Internal Revenue Code (IRC) Section 1031 (a)(1) states: No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of ‘like-kind’ which is to be held either for productive use in a trade or business for investment.” Wow. That’s a lot to digest, but essentially, 1031 exchanges simply allow for a deferment of capital gains taxes on investment property dispositions.
The “like-kind” definition mentioned in the IRC does not include primary residences, second homes, flips, or developments. If you are looking to defer taxes on your primary residence, however, there still is a way for you to do so- two, actually. The first option includes selling your primary residence, but exchanging the “investment portion” of your home, which could be a home office, room for rent, or the like. In this case, the percentage of your home used for investment purposes would be the percentage of income you wouldn’t be taxed on and you could invest in a new property. For example, if 20% of a million dollar home was taken up by a home office, $200,000 of the sale of the home could be used to purchase a new investment property and the capital gains taxes on this portion would not have to be paid immediately.
The second option for utilizing the 1031 exchange for a primary residence would include converting your residence into an investment property before selling. This would look like moving out into a rental home, senior community, or vacation home. From there, the primary residence would need to be rented out for the next two years at least. This would mean the property now qualifies as both investment property and primary residence because you lived in it for two of the last five years. In this case, you would keep the capital gain exemptions and exchange the balance into a new like-kind investment property. It is important to note that second homes that are not being rented out do not qualify for this tax exemption.
Please note that this is merely a guide for answering a few basic questions regarding a 1031 Exchange. For more detailed answers or applications on how this could apply to you, please reach out to your tax consultant and/ or real estate agent for more information.