A 1031 exchange lets real estate investors defer capital gains taxes by selling one investment property and reinvesting the proceeds into another like-kind property. While this strategy can delay a significant tax bill, it doesn’t eliminate the tax obligation entirely. Investors must still follow IRS rules and deadlines carefully. Knowing how to report a 1031 exchange on a tax return is an important part of real estate investing, as failing to do so properly can result in penalties or the loss of tax deferral benefits. The correct forms and timely reporting depend on the specific details of each exchange.
A financial advisor can you help you with a long-term strategy leveraging 1031 exchanges to keep growing your investment real estate portfolio.
1031 Exchange Essentials
Internal Revenue Code Section 1031 specifies rules that allow investors to do tax-deferred swaps of like-kind investment real estate. To qualify, the disposition of one relinquished property and acquisition of a replacement property must be parts of an integrated exchange transaction. Both the property sold and the one newly purchased must be held for business or investment use. This means primary residences or vacation homes cannot be exchanged. The relinquished and replacement properties must also be similar enough to count as like-kind.
Exchanges can take different forms. In a basic simultaneous swap, an investor trades one property for another directly. Another option, a deferred exchange, allows more time and flexibility to dispose of one property first, then subsequently obtain one or more replacement investment real estate assets.
Reverse exchanges start with acquiring the new property, then disposing of the old one. Investors generally need assistance from exchange facilitators. Facilitators can help ensure full compliance with 1031 requirements when doing deferred or reverse exchanges.
Reporting a 1031 Exchange
Even though investors defer taxes in a 1031 exchange, they must still report the exchange to the IRS. They must report it in the tax year when they begin the exchange by relinquishing the property, even if the transaction concludes in the following tax year.
After selling the relinquished property, investors have 45 days to identify potential replacement properties in writing. They must then receive the replacement property and complete the exchange either within 180 days of the sale or by the due date of their tax return, including extensions — whichever comes first. Missing either deadline invalidates the deferral and requires the investor to pay taxes as if it were an ordinary sale.
Investors can also pursue partial exchanges involving some cash or other property that isn’t like-kind. In these situations, only part of the tax obligation may be due immediately. If an investor relinquishes property but can’t acquire replacement property in time, they may treat any profits as an installment sale and spread the gain over future years. Many states also impose their own reporting requirements.
The deadline for reporting 1031 exchanges usually aligns with the federal tax filing deadline, typically April 15 for individuals. If the exchange isn’t complete by then, investors can request an automatic extension to delay filing until October 15. However, they must still pay any projected taxes by April 15.
1031 Exchange Forms
Taxpayers report exchanges on Form 8824, like-kind exchanges, attaching it to their returns. The form asks for:
- Descriptions of properties sold and purchased
- Key dates including when the sold property was originally acquired and when the replacement property was identified and acquired
- Any connections between the exchanging parties (either direct or indirect)
- Value and basis details on properties exchanged
- Calculations for any realized and recognized gains or losses
If the property exchanged is depreciable real estate, some taxes may have to be paid now rather than deferred. This is due to depreciation recapture rules and occurs when there are significant differences between the properties exchanged. Trading unimproved land for improved, income-generating real estate is one example of such an exchange.
When depreciation recapture is triggered, any gains get taxed at ordinary income rates rather than the typically lower long-term capital gains rates. The amount recaptured reflects the depreciation previously deducted on the older property. In most cases, this recapture tax obligation would need to be reported on Form 4797, Sales of Business Property, if the relinquished property was used for business purposes.
Choosing the Right Forms
In some cases where the exchanged property was held just for investment, not business use, the depreciation recapture and other gains may instead get reported on Schedule D. The correct type of form, either Form 4797 or Schedule D, depends on complex factors. This is where it may be helpful to consult a tax professional before filing.
Getting these forms right is important. That’s because the IRS also gets notification of the relinquished property’s sale via Form 1099-S from the facilitator of the exchange. Form 8824 shows the tax authorities the transaction qualified for deferral through a valid 1031 exchange.
In any case, taxes are only deferred, not eliminated. When you later sell the replacement property in a non-exchange transaction, the original deferred gain plus any added gain gets taxed. The cost basis, which is used to determine the gain, carries over from the old property to the new property.
Bottom Line
Reporting 1031 exchanges properly requires tracking dates, filling out Form 8824 detailing information on properties traded and calculating any recognized gain. While taxes are postponed on these transactions, they aren’t excused forever. The tax liability on any gains is only deferred to a later sale. Keeping the right records on exchanges is critical to maintaining this deferral. Knowing how to report a 1031 exchange on a tax return can help you avoid any errors that would result in the IRS canceling your tax deferral and requiring you to pay taxes on your next return. Since these transactions and their tax effects are so complex, consult an experienced tax professional before filing your return.
Tax Planning Tips
- Given the intricate tax rules for 1031 exchanges, consider meeting with a financial advisor to ensure you are complying fully. As well as making best use of the tax deferral benefits when investing in real estate. SmartAsset’s free tool matches you with vetted financial advisors who serve your area. You can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s income tax calculator to estimate your obligation or refund for this year.
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