What is a 1031 Exchange?

If you are a real estate investor or plan on becoming an investor, then you’ll want to understand the benefits of a tax-deferred 1031 exchange. When selling an investment property, you must pay capital gain taxes on the profit made.

The term 1031 exchange refers to the Internal Revenue Code Section 1031. It states that when selling an investment property, an investor is not required to recognize a gain or loss if they purchase another like-kind property with the profit gained from the sale of the first property.

To qualify as a 1031 exchange, the property being sold and the property being acquired must be like-kind.  What does this mean? First, the properties must both be of similar value. The IRS requires the net market value and equity of the property purchased must be the same or greater than the property sold. Helpful tip: broker’s fees, qualified intermediary fees, filing fees, escrow fees, inspections, etc. may be applied toward the total cost of the new property. Second, the investment properties must also be of the same nature or character, even if they differ in quality. Therefore, you can do this exchange with almost any type of property as long as it’s for business or investment purposes.

By participating in the 1031 exchange, investors can put off paying capital gains for quite a while. If they do decide to eventually sell without purchasing another property, they will then be required to pay capital gains on their final investment property.

Rules:

• Investors must identify the replacement property within 45 days and must close on the property within 180 days.
• The exchange can only be used for investment or business property, not personal property (it can’t be a primary residence).
• The tax return and the name appearing on the title of the property being sold, must be the same as the tax return and title holder that buys the new property. The only exception to this rule would be in the case of a single member limited liability company. The single member limited liability company may sell the original property and that sole member may purchase the new property in their individual name.
• The exchange process needs to start prior to the sale of the first property. A qualified intermediary will work with the investor’s title company to make sure the sale is handled properly. The proceeds from the sale of the investment property are sent directly to the qualified intermediary where they will stay until the closing of the replacement property. The investor cannot directly receive the proceeds or it will nullify the exchange.

If an investor is unable to follow these rules, then taxes will be due following the 180 day period.

Stepped-Up Basis: If an investor continues with 1031 exchanges throughout their lifetime and eventually passes away, leaving his investment property as an inheritance then the stepped-up basis would apply. For example, the investor originally purchases the property for $100,000 and now fair market value is $300,000, the heir could sell it for $300,000 without having to pay the capital gains.

Overall, the 1031 exchange is very beneficial to investors if they follow all of the mandatory rules. It can be a complicated process and timing is crucial. It’s important to work with professionals who thoroughly understand the process.