What the IRS Wants You to Know About 1031 Exchanges

Conducting a like-kind exchange under Section 1031 of the Internal Revenue Code (also referred to as a 1031 exchange) can provide access to substantial—and potentially indefinite—savings on federal income tax. But, strict rules apply, and taxpayers who fail to follow these rules can find themselves facing scrutiny from the Internal Revenue Service (IRS). As 1031 exchange specialists, we are intimately familiar with these rules, and we are also familiar with the issues that tend to trigger IRS audits.

Important Information About 1031 Exchanges from the IRS

To help taxpayers avoid mistakes when conducting 1031 exchanges, the IRS has published some useful resources online. These include the IRS’ Real Estate Tax Tips for Like-Kind Exchanges and the Instructions for completing IRS Form 8824 (which is used to report 1031 exchanges). Taking cues from these resources, here are some important facts the IRS wants taxpayers to know about the like-kind exchange process:

Section 1031 Only Applies to Real Estate

Today, Section 1031 only applies to real estate. While U.S taxpayers used to be able to use like-kind exchanges to indefinitely defer gain on the sale of appreciated personal property, this changed with the enactment of the Tax Cuts and Jobs Act. As a result, any articles or other online resources that discuss using 1031 exchanges in connection with personal property are outdated.

Section 1031 Only Applies to Real Estate Used for Business or Held for Investment

Contrary to popular belief, Section 1031 does not allow you to avoid paying federal income tax when you sell your primary residence for more than you paid. Instead, homeowners are entitled to an exclusion under Section 121 of the Internal Revenue Code—and they must properly claim this exclusion in order to avoid unnecessary tax liability.

Section 1031 only applies to real estate used for business or held for investment. If you have a second home or if you expect to earn more profit from the sale of your home than the Section 121 exclusion allows, you may want to consider taking the necessary steps to transform your home into an investment property.

“Like-Kind” is a Very Broad Term

While many taxpayers have concerns about what constitutes a “like-kind” property for purposes of conducting a 1031 exchange, the definition of this term is very broad. As the IRS explains, “[r]eal properties generally are of like-kind, regardless of whether they’re improved or unimproved.” The only major exception to this rule pertains to overseas real estate: Real property owned outside of the United States is not considered to be of “like-kind” with domestic real estate—even if the two properties are otherwise of similar nature, character, grade and quality.

U.S. Taxpayers Must Report Their Like-Kind Exchanges

If you conduct a transaction that is eligible for like-kind exchange treatment under Section 1031, it is not simply enough to know that your transaction is eligible. To avoid triggering unwanted scrutiny from the IRS, you must timely report your like-kind exchange using IRS Form 8824. As the IRS also explains, “[i]f during the current tax year you transferred property to another party in a like-kind exchange, you must file Form 8824 with your tax return for that year.” Like-kind exchanges conducted across multiple tax years can be tricky to report correctly, and this is just one of the numerous issues with which our 1031 exchange specialists can help.

Failing to Properly Conduct or Report a 1031 Exchange Can Trigger Steep Penalties

Just like other violations of the Internal Revenue Code, failing to properly conduct or report a 1031 exchange can trigger steep penalties. As we mentioned above, several strict rules apply. These rules govern everything from the timing of 1031 exchanges to the procedural requirements for transferring the proceeds from the sale of the “relinquished” property.

Due to these potential concerns, taxpayers who are thinking about conducting a like-kind exchange should work with specialists who can help them navigate the process—and document the process—successfully. While there are risks involved with failing to strictly comply with Section 1031, taxpayers should not let these risks deter them from taking advantage of the significant tax benefits that are available.

Contact the 1031 Exchange Specialists at 1031 National Services

If you would like to know more about the rules and requirements for conducting a 1031 exchange or reporting an exchange to the IRS, we invite you to get in touch. To schedule a free consultation with one of our 1031 exchange specialists, please call 888-872-1031 or request an appointment online today.