When and How to Report a 1031 Exchange on Your Tax Return

A 1031 exchange allows certain real estate investors to defer capital gains taxes when selling one investment property and reinvesting proceeds from the sale into another similar property. Taxes are only postponed, not eliminated, and investors still need to properly report 1031 exchanges to the IRS. Multiple deadlines for enacting and reporting exchanges apply, and investors also need to use specific tax forms depending on the characteristics of an individual exchange. Work with a financial advisor to craft an optimal long-term strategy leveraging 1031 exchanges to keep growing your investment real estate portfolio’s pre-tax basis and compound gains over multiple cycles.

Internal Revenue Code Section 1031 specifies rules that allow investors to do tax-deferred swaps of like-kind investment real estate. To qualify as allowable, 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 newly purchased one need to 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, who can help ensure full compliance with the multitude and variety of 1031 requirements when doing deferred or reverse exchanges.

Even though taxes are being deferred, 1031 exchanges must be reported to the IRS. The exchange must be reported in the tax year when the investor relinquishing the property begins the exchange. That remains the case even if the transaction finishes the following tax year.

Investors have 45 days from when they sell the relinquished property to identify potential replacement properties in writing. Then replacement property must be received and the exchange completed within the earlier of 180 days of the sale of the exchanged property that is being given up or by the due date of the tax return including extensions. Failing to meet either deadline will invalidate the deferral and require taxes to be paid as if the transaction were an ordinary sale.

It’s also possible to do partial exchanges involving some cash or other property that is not like-kind. In these cases, only some tax obligation might fall due currently. If the investor relinquishes property in a 1031 exchange but is unable to acquire replacement property in time, any profits could potentially still get treated as an installment sale with the gain spread over future years. Various states also have their own reporting requirements.

The deadline for reporting 1031 exchanges normally is the same as the deadline for filing federal returns, typically April 15 for individuals. If the exchange is not completed by then, an automatic extension may be requested, delaying the required filing date until October 15. In the event of a delay, projected taxes should still be paid by April 15.

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.

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, so consult a tax professional before filing.

Getting these forms right matters, because the IRS separately 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.

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. If reporting isn’t done correctly, tax deferral could be canceled so that taxes are due on your next return. Since these transactions and their tax effects are so complex, consult an experienced tax professional before filing your return. 

• Given the intricate tax rules for 1031 exchanges, consider meeting with a financial advisor to ensure you are complying fully and making best use of the tax deferral benefits when investing in real estate. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and 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.

Photo credit: ©iStock/andresr, ©iStock/Thicha Satapitanon, ©iStock/nuttapong punna