Understanding the 1031 Exchange

While roughly 200,000 people call Cape Cod their year-round home, more than 500,000 are here in the summer months, meaning that many of Cape Cod’s homes are purchased for vacation or investment purposes.  If you own an investment property on the Cape or elsewhere, and have thought about upgrading to a nicer property – perhaps one closer to the water that will bring in greater income – then you should understand Section 1031 of the U.S. Revenue Code, more commonly known as the 1031 Exchange, which allows you to defer the capital gains tax on your current property and apply it to your newly purchased property.

Here are the basic rules that govern the use of a 1031 Exchange.

  1. It must be investment property. You cannot use the 1031 Exchange on your primary residence or even a vacation home that was not used for investment purposes. It is strictly for use with investment assets, including but not limited to real estate.
  2. You must engage a Qualified Intermediary. A Qualified Intermediary is a person or company that facilitates the 1031 exchange by holding the funds from the sale of your first property until they can be given to the seller of your new property. This person or company can have no other formal relationship with any of the parties involved in the transaction.
  3. You must be investing MORE money, not less.  You must must use ALL of your net proceeds from the sale of your property to purchase the new investment property (or properties).  You can invest more than that amount, but you cannot invest less.  Think of Monopoly.  To get a hotel, you need to exchange one or more houses plus some additional capital.
  4. Properties must be “Like Kind”.  The 1031 Exchange can only be used to exchange “similar types of investments”.  But pretty much all real estate is considered “similar kind”.  You can even exchange a commercial building for a rental home.  You can exchange a condo for an apartment building.  You can exchange a 2-family home for a restaurant property.  But you cannot exchange stock or a valuable collector’s painting for real estate.
  5. You can buy multiple properties. If you so choose, you can buy three investment properties in exchange for your original one investment property, as long as the net cost of the three new properties is greater than the net sale of the original property. Likewise, you can SELL multiple investment properties in exchange for one new investment property,
  6. There are time limits on the Exchange. In general, you must identify your replacement property within 45 days of the sale of your original property, and then close on the new property within 180 days of the sale of your original property.

These are the most basic and general rules associated with the 1031 Exchange option.  If you are considering a 1031 Exchange, you should speak with your financial/tax advisor(s) to fully understand all of the rules and to make sure it makes sense for your particular situation and portfolio.  For assistance in buying or selling an investment property on Cape Cod, please contact Marie.