What is a 1031 Tax-Deferred Exchange?
When you sell property, you generally have to pay tax on the gain. Section 1031 of the Internal Revenue Code allows a taxpayer to defer the tax normally due on the sale of property held for investment or used in business or trade when the sale property is exchanged for another “like-kind” investment property. These exchanges provide opportunity to preserve and grow holdings.
Why do I need a qualified intermediary?
IRS regulations have defined several “safe harbors” that help establish the boundaries for exchanges. As long as your transaction is structured within these boundaries, it is generally presumed that your exchange will be allowed.
How does a 1031 Tax-Deferred Exchange work?
You should always discuss the applicability of a 1031 Exchange with your legal or tax advisor. Before transferring the property you are selling, contact your local title and settlement agency to be your qualified intermediary (QI). Your QI will produce the required exchange agreement and other important documentation that must be in place before you transfer your property.
What are the advantages?
There are many advantages to a 1031 Exchange, whether you are an individual with one rental house or a corporation with a shopping center. The primary advantage is that you may sell property without incurring any immediate tax liability. You may then use these tax-deferred proceeds to invest in another project. That keeps the money you would have paid in taxes working for you.
How must the exchange be structured to avoid immediate tax?
You must reinvest all the proceeds from the sale of your property and purchase the new property of equal or greater value to avoid paying any capital gains tax. You must also replace any existing debt with an equal or greater amount of debt. Any proceeds not reinvested in the replacement property and/or any debt relief is considered “boot” and will be taxed.
Are there any disadvantages?
There are three primary disadvantages:
- You may not use any of the net proceeds from the sale of your property for anything except investing in the replacement property, without tax consequences.
- If you identify property that you want to buy, but decide after day 45 that you don't want it, your qualified intermediary (QI) must still hold the proceeds until the 181st day. Returning the funds before then would be an early disbursement and contrary to the exchange agreement entered into between you and your QI.
- You will have a reduced basis in your replacement property, resulting from the carry-over basis of the property you sell. If you eventually sell the replacement property, you will realize more gain than if you had acquired the property through a straight sale and purchase.
Will I have to pay the deferred tax later?
If you eventually sell the replacement property outright, rather than completing another 1031 Exchange, you will be required to pay capital gains tax on the replacement property.
What is like-kind property?
“Like-kind” property does not mean “same-type” property. All real property is like-kind with all other real property. Any real estate held for investment or business can be exchanged for any other real estate to be used for investment or business. For example, you may exchange a rental house for a shopping center or undeveloped land for an apartment building.
What property does not qualify?
- Residence or second home: You may not exchange your residence or second home, nor may you acquire as your replacement property a house to be used as either. You could “convert” your second home to a valid exchange property and establish this intent by properly renting it and holding it as a legitimate rental property. Consultation with a tax advisor is important if you change how you intend to hold the property.
- Primarily for sale: The intent to hold property “primarily for sale” will prevent it from qualifying for 1031 Exchange treatment. Most properties owned by developers, builders and people who perform rehabilitation work are held primarily for sale and may not be the subject of an exchange. When these properties are sold, they are subject to ordinary income taxes rather than capital gain taxes.
- Other: Partnership interests, notes secured by real property, contract vendor's interests and foreign property do not qualify.
Should I buy a title insurance policy?
The IRS does not require that the exchange happen simultaneously, and, indeed, from a practical standpoint, that is often difficult to arrange. You have 45 days from the date of closing on your property to identify your replacement property or properties. From the date of closing, you have the earlier of 180 days after the transfer of your property or the due date of your federal income tax return (including extensions) to close on the property or properties you identified.
How do I identify property?
The replacement property must be identified in writing and delivered to the qualified intermediary by the end of the 45th day. The replacement property must be identified with specificity, either by address, tax map and parcel number, unit number, etc. You may identify more than one property as replacement, but you must comply with one of three rules:
Can I buy replacement property first?
This situation is called a reverse exchange. If at all possible, it is better for you to sell your relinquished property first, before acquiring the replacement property. Sometimes, however, this is just not possible, and the replacement property must be acquired immediately to avoid losing the deal.
How does a reverse exchange work?
When you purchase your replacement property before you sell your initial property, this is known as a reverse exchange. Although not the preferred exchange structure, this situation can be accommodated through the following steps.
Are 1031 Exchanges limited to real estate?
No, 1031 exchanges can be applied to personal property as well as real estate. The tax code states that as long as the property is being used in a trade or business or held for investment, it may be exchanged for property of like kind. “Like-kind” has a broad definition as applied to real estate, but takes on a literal meaning when referring to personal property.
What happens if I change my mind?
After the sale of your relinquished property and the deposit of the proceeds with the qualified intermediary (QI), if you are unable or unwilling to identify a replacement property, the proceeds, less the fee of the QI, will be returned to you with all accrued interest on the 46th day.
What is an exchange agreement?
An exchange agreement is the contract between the qualified intermediary and you. It sets out the duties and obligations of both parties, and also sets out the conditions under which your proceeds can be released to you.
What is a cooperation clause?
When you contract to sell your property, you make the buyer aware, by special language in the contract, of your intention to do a 1031 Exchange. This will not delay the closing nor will it cause the buyer any additional expense. A similar clause must be inserted in the contract for your replacement property to advise the seller of your intention to do a 1031 Exchange.