1031: You Can't Have Something for Nothing

Ever wish you can just, literally, swap your property with another one from somewhere? Section 1031 of the Internal Revenue Code allows you to do just that, as long as the property that you want is for investment or production purposes only. The new property only has to be somewhat similar to the old one that you have, although the word “similar” is very subjective and adds difficulty to the transaction.

This is why most real estate exchanges are facilitated by reliable exchange companies that can help you find a brand-new property and swap it with another one of your own. They make sure that the property you've swapped with doesn't saddle with you any unlawful gains or losses and that you're only required to pay little or no tax during exchange. However, 1031 requires that any property being swapped needs to be properly identified and exchanged within 180 days after the transaction was made, or else the Internal Revenue Service (IRS) won't recognize the transaction.

Businesspeople can use 1031 to change the form of their investment without getting any attention from the IRS. Real estate investors can also use the 1031 to, say, sell off a single-family home in exchange for a condominium or apartment unit, or a hotel for an office building. This is known as exchanging like-kind real estate and has been practiced by investors for at least 30 years now.

A 1031 on Residential Property? It's Possible

Section 1031 of the Internal Revenue Code, also known simply as 1031, defers taxes for gains on any property or asset if they're reinvested in a like-kind exchange. If you sold a $100,000 property for twice the amount, the $100,000 gain won't be subject to tax as long as it's invested in another property. This is in line with what Section 1031 actually says. It states that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business.”

Speaking of trade or business, does this imply that simple homeowners aren't qualified for a 1031? While it states that the property must be for productive use, experts say homeowners can file a 1031 in a number of instances. In this case, you need to know the so-called “two-of-the-last-five-years rule” where the homeowner must have lived in the house for two years. It also states that the house has been turned into an investment property for the next three years.

One way to turn a residential property into an investment is by renting it out. Homeowners can move out of the house after their second year of residing there, but have to rent it out for the next three years to qualify for a 1031. Make sure you don't make your new home your primary residence before the two-year period, although there are efforts to reduce the time frame to just one year.