“What is a 1031 exchange?”
The answer can be quite simple and somewhat complex. A properly structured 1031 exchange (Internal Revenue Code Section 1031) allows the owner of specific types of real estate with appreciated value to defer Federal capital gains taxes on the sale of their property, as long as they reinvest the proceeds of the sale into another property.
IRS Section 1031 (a)(1) states: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Any real estate held for productive use in a trade or business or for investment, improved or unimproved, is considered “like-kind.” The concept of “ like kind” can be broad Like-kind refers to the property’s nature and character as opposed to its quality.
- Farmland for Timberland
- Vacant land for Commercial
- Apartment for Single Family Rentals
- Vacation rental for Duplex
- Commercial for Industrial
- Retail for Apartment
- Industrial for Office building
These are just a handful instances, many more combinations are available, talk with a 1031 specialist about your specific situation. Note: Owner occupied single family residential homes do not usually qualify for 1031 exchange, however there are circumstances where this may be allowed if the residence is part of income producing property, (i.e. farmhouse, residence as part of apartments, storefront with residence, ect…)
Main areas to consider regarding 1031 exchange rules are
- The properties involved in the transaction must be “Like Kind” (described above).
- Proceeds from the sale must go through a Qualified Intermediary, funds cannot be handled by the exchanger or some other agent/intermediary, (see links below for intermediary sources).
- In order to reap the full benefit of the tax deferment, the entire cash or monetary proceeds from the original sale must be reinvested towards acquiring the new property purchased. A portion of the cash proceeds from the sale of the appreciated property can be retained if the new property is of lesser value, however the portion retained (AKA “Boot”) will be taxed without deferment.
There are two critical timelines that must be adhered to for a successful 1031 property exchange.
The Identification Period: This is the crucial period during which the party selling a property must identify other replacement properties that he / she proposes or wishes to buy. It is not uncommon to select more than one property. This period is scheduled as exactly 45 days from the day of selling the relinquished property. The 45 day timeline must be followed under all circumstances and is not extendable in any way, (even if the 45th day falls on a Saturday, Sunday or legal holiday).
The Exchange Period: This is the period within which a person who has sold the relinquished property must purchase the replacement property. This period ends at exactly 180 days after the date on which the person sells the property relinquished.
Typical steps to a successful 1031 Exchange
Step 1. Place the relinquished property on the market.
Find a qualified real estate professional who understands the in’s and out’s of the 1031 exchange process. The real estate agent must include the proper language in the listing to make potential buyers aware of 1031 compliance.
Step 2. Search for replacement property
If the replacement property isn’t identified in advance, it’s a good idea to begin the search right away, even while the property to be relinquished is on the market. As soon as the relinquished property is sold, there is a 45-day window to identify the replacement property, and 180 days to close on the replacement property. The guidelines give the exchanger the ability to identify up to three replacement properties of any value that total less than 200% of the value of the relinquished property.
Step 3. Find a qualified intermediary
A 1031 exchange requires the utilization of a qualified intermediary. A qualified intermediary acquires and retains the proceeds or titles from the sale of the properties until they are finalized. Acting as an in-between, an intermediary enters into a written exchange agreement with the buyers and sellers.
Step 4. Close the sale of the relinquished property
The documents associated with the closing must state the buyer’s acknowledgment of the 1031 exchange. The close of the sale on the relinquished property is just like any standard real estate transaction, although the funds are transferred into the intermediary’s account instead of into that of the seller / exchanger.
Step 5. Close on replacement property and complete exchange
The investor, intermediary, title company and agent work together to finalize and close the exchange. Once the acquisition of the replacement property is completed and the title is secured, the intermediary transfers the funds and title to the exchanger, which finalizes the exchange.
These guidelines are the tip of the iceberg of what can be accomplished using the 1031 exchange. Talk to a qualified 1031 expert to find out how your particular situation could benefit from this valuable tax deferment tool.
Below are links to 1031 exchange Companies we have had good experiences dealing with in the past. Their websites are packed full of valuable information in helping make the decision on whether a 1031 exchange is right for you.
At Realworks we specialize in helping you sell and buy exchange properties. Get in contact for a no obligation conversation about your specific needs.
*Article is published as an informative piece and based on the tax laws as of the date of writing. In no way is this post a substitute for proper legal and or tax advice. Realworks LLC and the author recommend consulting a CPA, tax attorney, 1031 intermediary or other professional services who specialize in tax codes and 1031 exchanges.