What is a 1031 exchange, and how do I take advantage of it?

Deferring tax payment is the main objective of the 1031 exchange program


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As with any big financial transaction, an apartment sale in New York City involves paying taxes. If it’s an investment property, rather than your primary residence, you can be taxed on your capital gains—i.e., the profit you make on the sale of the apartment or building. 

That’s why many New Yorkers turn to a popular tax deferral program called the 1031 exchange, which allows you to put off paying tax on these kinds of properties if you reinvest the money in a similar property within a tight timeframe. Dean Roberts, real estate attorney with Norris McLaughlin says, “Any tax payment that’s deferred is a good tax payment.” 

It’s a good strategy if you bought during a downturn or had insider pricing on an apartment, or have held onto the place for several years, and seen the value increase—all reasons to consider deferring the capital gains tax payment. If you do the exchange, the profit stays with you. 

“Eventually you will pay this tax but if you put off the payment for 10 years, you will have had the money for 10 years and haven’t had to pay taxes,” says Roberts.

Keep in mind, there are plenty of rules and red tape associated with the 1031 exchange program.  

The trade must involve ‘like-kind’ properties

The investment property needs to be exchanged for a similar kind of property but it’s possible to exchange a residential property for commercial. 

It's also possible to use the 1031 exchange if you are selling a vacation property, but most likely, you'll need to have rented it out as an investment for at least six months prior to the sale in order to qualify. 

Tight timelines for trades

In order to comply with the rules, you will have to identify a property you want to buy within 45 days of the sale of your qualifying apartment. The next deadline is closing on the purchase of your replacement property within 180 days of the original sale. This gets complicated if you're trying to use a 1031 exchange to buy in a new construction or pre-construction building, where delays in the delivery timeline can affect the closing date. 

You’ll also want to take into consideration your tax filing deadline, especially if you are selling towards the end of the year. You’ll want the trade to take place within the same tax year or with the proper planning, shift it into another tax year. 

Funds need to be with an intermediary

In between the sale of your first property and the closing on the second, your profits need to be in escrow with a real estate attorney. This is an important part of the process. 

“It is because of these very specific issues that most people use a 1031 servicer to complete the transaction,” says Roberts.

—Earlier versions of this article contained reporting and writing by Virginia K. Smith.