If you’re a real estate investor – or if you’d like to become one – you may be able to take advantage of a 1031 exchange. But what is a 1031 exchange, what are the rules about using it, and can you use it for a vacation home? Here’s what you need to know.

What is a 1031 Exchange?

A 1031 exchange is a switch – you swap out one investment property for another. The reason investors do this is to defer capital gains taxes. When you don’t have to pay taxes for selling an investment property, your investment can continue to grow; you just take the profits from the sale and invest them in a different property.

Investors can roll over the gain from one investment to the next indefinitely. Uncle Sam won’t collect his cut until you sell the last property for cash – and sometimes, people never sell those properties.

(And in case you were wondering, it’s called a 1031 exchange because the allowance for the process comes from IRS code Section 1031.)

A Word on Capital Gains Tax

Capital gains taxes are taxes on the growth in an investment’s value when someone sells the investment. For example, if you buy something for $10 and it’s worth $20 when you sell it, you are taxed on the $10 it gained in value. Essentially, capital gains tax is a government fee, and it only becomes due when you sell your investment. You could hang on to that $10 item forever and never pay a dime in capital gains taxes. Only some types of property are subject to this tax – and real estate used for an investment is one of them.

What Does “Like-Kind” Mean in a 1031 Exchange?

Most exchanges must be of “like-kind,” which means that you must change one investment property out for another. You can’t swap out your investment property for your next home. (There are ways to do a 1031 exchange on vacation homes, but that’s something you’ll want to talk to a Silicon Valley REALTOR® and your financial planner about.)

Don’t let the phrase like-kind confuse you. It’s okay to exchange a multifamily property for a commercial building, a piece of land for a large apartment complex, or just about anything else that you’ll use as an investment.

Rules and Timelines for 1031 Exchanges

Most 1031 exchanges are delayed. All that means is that it’s pretty rare to find a property you want to invest in at the same time that someone else wants to buy your existing property. There are two important rules to keep in mind if you’re considering a delayed 1031 exchange:

  • The 45-day rule
  • The 180-day rule

The 45-Day Rule in a Delayed 1031 Exchange

You must have an intermediary – a neutral third party you trust – hold your money from the sale of your property for 45 days. You cannot touch the money until after 45 days have passed or you’ll ruin the exchange and end up paying capital gains taxes.

Also, within that 45 days, you must specify the property you want to replace your old property with. According to the IRS< you can designate up to three properties, as long as you eventually close on one of them. (That’s where the 180-day rule comes in.)

The 180-Day Rule in a Delayed 1031 Exchange

You must close on your new property within 180 days of selling the old property.

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