IRS 1031 Tax Deferred Exchange

What is "1031 Tax Deferred Exchange?"

Section 1031 of the Internal Revenue Code provides for the deferral of capital gains taxes with a tax-deferred exchange. A tax-deferred exchange, or a like-kind exchange, is a method by which a real property owner can sell his property and then reinvest the proceeds in ownership of like-kind property and defer the capital gains tax.

Capital Gains Tax

One of the reasons people choose to use a 1031 exchange is to defer paying capital gains tax on their business or investment real estate. Capital gains tax is defined as the tax levied on profits from the sale of capital assets. The process gives the 1031 exchanger more buying power because the capital gains taxes are deferred. Capital gains taxes on the sale of the property are deferred until the like-kind property is sold at a future date.

A Qualified Intermediary (QI) Must Facilitate Your Exchange

The QI is a professional 1031 exchange intermediary or entity that can legally hold funds to facilitate a 1031 exchange. The use of a Qualified 1031 Exchange Intermediary is essential to completing a successful 1031 exchange process.

To be qualified, the 1031 exchange intermediary must not be a relative or an agent of the exchanging party. The QI performs several important functions in the 1031 exchange process including creating the exchange of properties, holding the 1031 exchange proceeds and preparing the legal documents.

Who should consider a 1031 exchange?

If you have real property held for investment or used a second home 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.

Why should you consider a 1031 exchange?

  • Defer paying capital gains taxes. A properly structured exchange can provide real estate buyers with the opportunity to defer all of their capital gains taxes.
  • Leverage.
  • Upgrade or consolidate property.
  • Diversify. Own multiple properties rather than just one.
  • Relocation to a new area.
  • Differences in regional growth or income potential.

How Do You Qualify for 1041 Tax Deferred Exchange

Under Internal Revenue Code (IRC) Section 1031, a real property owner can sell certain 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. In order to defer all capital gains tax in a like-kind exchange, the real estate buyer should follow these guidelines:

  • The exchange proceeds must be reinvested in the acquired property and the acquired property must have the same or greater value.
  • Obtain EQUAL OR GREATER EQUITY in the replacement property.
  • Obtain EQUAL OR GREATER DEBT in the replacement property or have a reduction in debt that is offset with additional cash at closing from the taxpayer.
  • Receive nothing except like-kind property.

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.

1031 Timeline

Identification Period: Within 45 days of selling the relinquished property (date of closing, not contract acceptance) 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.

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.

Replacement property identification

3-property rule: You may identify any three properties as possible replacements for your relinquished property. More than 95% of exchanges use the 3-property rule.

200% rule: You may identify any number of properties as possible replacements for your relinquished property as long as the aggregate value of those properties does not exceed 200% of the value of your relinquished property.

95% exemption: You may identify any number of properties as possible replacements for your relinquished property as long as you end up purchasing at least 95% of the aggregate value of all properties identified.