What is a 1031 exchange?
Under section 1031 of the Internal Revenue Code, a real property owner can sell his property and then reinvest the proceeds in ownership of like-kind property and defer the capital gains taxes. To qualify as a like-kind exchange, property exchanges must be done in accordance with the rules set forth in the tax code and in the treasury regulations. The 1031 exchange can offer significant tax advantages to real estate buyers. Often overlooked, a 1031 exchange is considered one of the best-kept secrets in the Internal Revenue Code.
Who should consider a 1031 exchange?
If you have real property that will net you a gain upon sale (generally property that has been substantially depreciated for tax purposes and/or has appreciated in fair market value), then you are exactly the person who should consider a 1031 exchange.
There are 5 tax classes of property:
1) Property used in taxpayers trade or business.
2) Property held primarily for sale to customers.
3) Property which is used as your principal residence.
4) Property held for investment.
5) Property used as a vacation home.
Section 1031 applies to the first and fourth categories, and potentially the fifth category. Business use is defined as, “To hold property for productive use in trade or business.” Property retired from previous productive use in business can be qualifying property. Investment purpose defined as real estate, even if unproductive, held by a non-dealer for future use or increment in value is held for investment and not primarily for sale. Investment is the passive holding of property, for more than a temporary period, with the expectation that it will appreciate. Property held for sale in the immediate future is not held for investment.
What are the 1031 exchange rules?
The real property you sell and the real property you buy must both be held for productive use in a trade or business or for investment purposes and must be like-kind.
The proceeds from the sale must go through the hands of a qualified intermediary and not through your hands or the hands of one of your agents or else all the proceeds will become taxable.
All the cash proceeds from the original sale must be reinvested in the replacement property – any cash proceeds that you retain will be taxable.
The replacement property must be subject to an equal level or greater level of debt than the relinquished property or the buyer will either have to pay taxes on the amount of the decrease or have to put in additional cash funds to offset the lower level of debt in the replacement property.
Is There a 1031 Timeline I Have to Follow?
Yes, there are two “Periods” you have to follow exactly.
The Identification Period … Within 45 days of selling the relinquished property you must identify suitable replacement properties. This 45 day rule is very strict and is not extended should the 45th day fall on a Saturday, Sunday, or legal holiday.
The Exchange Period … The replacement property must be received by the taxpayer within the “exchange period,” which ends within the earlier of . . . 180 days after the date on which the taxpayer transfers the property relinquished, or . . . the due date for the taxpayer tax return for the taxable year in which the transfer of the relinquished property occurs. This 180-day rule is very strict and is not extended if the 180th day should happen to fall on a Saturday, Sunday or legal holiday.