Understanding ‘1031 Exchange’ for Investment Buyers & SellersTerry Riffe | April 2, 2015
1031 Exchange for Investment Buyers & Sellers
What is a 1031 Exchange?
Normally when you sell property, you realize a gain or loss in that transaction. Section §1031 of the U.S. Internal Revenue Code provides an exception to that general rule, which states that: “No gain . . . shall be recognized on the exchange of property held for productive use in trade or business or for investment if such property is exchanged solely for property of like kind . . .” The concept is simple: In a 1031 exchange, you exchange Property “A” for Property “B”. The sale proceeds from “A” are used to pay for the purchase of “B”. By using a “Qualified Intermediary” to transfer both properties and funds, rather than you doing so directly, your tax liability is deferred.
What are the benefits of a 1031 Exchange?
Instead of selling a property, paying taxes on it, and then using the reduced after-tax proceeds to buy other real estate, IRC §1031 allows you to defer the capital gains tax owed. This enables full reinvestment of your sale proceeds. The amount not paid in capital gains tax to federal and state governments creates increased equity in your investment. Tax deferment increases the availability of your money which can be invested into better property(s) of greater value. Tax deferment is leverage, and leverage creates wealth. In effect, you receive an interest-free loan from the government, in the amount you would have paid in taxes.
What are the Basic Requirements for a Successful Exchange?
There must be at least 2 properties in an exchange: One (or more) that you are selling, and one (or more) that you are replacing it with. The properties being exchanged must “qualify” – They must be held for use in trade or business or for investment.
The properties that you are exchanging do not have to be identical, so you can exchange land for warehouse, office for rental home, etc. Property that you own for personal use does not qualify for a 1031 exchange.
To defer ALL of your Capital Gains:
The purchase price of your replacement property(s) must be equal to or greater than the sales price of your relinquished (sold) property(s). All of your sale equity (cash) must be reinvested in the replacement property(s). You MUST use a “Qualified Intermediary” (Accommodator). The IRS will not allow you to receive cash proceeds or take “constructive receipt” of the funds in any way, or else you will be taxed.
What are the timing requirements?
From the day of closing on your first sale, you have up to 45 days to identify potential acquisition candidates and 180 days to close on the purchase of your replacement property.
So if I’ve contracted to sell a property but not yet closed, it is still OK to do an exchange?
You are still OK. But, again, once you have closed on your sale, it is too late. You cannot close and then re-open it to do an exchange. Therefore, if you selling and want to do a 1031 exchange call the accommodator immediately.
What if I have closed on the first sale, but I haven’t touched the money?
Sorry, too late! You are responsible for the tax on the capital gain.
I know I have a maximum of 45 days from the day of closing on the sale escrow in which to identify my replacement property. How do I do this?
Identification must be written, specific, timely, and delivered to a qualified, unrelated third party. There are three distinct rules for identification:
~“3-Property Rule”: up to 3 potential properties, no matter what their value (the most popular choice by far), or
~“200% Rule”: any number of properties, but the total value cannot exceed twice the value of the relinquished property, or
~“95% Rule”: any number of properties, but you must close on 95% of the aggregate value of those identified properties (very rarely used).
How can I receive more information on the 1031 exchange?
We have the experience to assist you with your 1031 Tax Deferred Exchange. Just remember that the investment properties must be “Like Kind” and the time frames are very important. Email email@example.com , or call us at 1-407-800-0888.