A 1031 exchange, commonly known as a tax deferred exchange, is a method of selling your property and acquiring another property within a specified period of time. The process of selling a property and buying another are practically identical to a standard sell and buy situation, except that a “1031 exchange” is unique because the entire transaction is treated for tax purposes as an exchange and not a simple sale. These exchanges are sometimes mistakenly called “tax free exchanges” because the exchange transaction itself is not taxed in the year it occurs, but in reality the taxes are simply deferred.
Tax deferred exchanges are authorized by Section 1031 of the Internal Revenue Code and it is important to understand the components involved. The transaction must be structured in such a way that it is in fact an exchange of one property for another, rather than the taxable sale of one property and the purchase of another. Following Section 1031 can be quite complex and most investors choose a real estate or tax attorney, or tax-deferred exchange specialist, to assist them. One mistake or misinterpretation of the Code can void the exchange and its tax benefits.
Any property owner or real estate investor should consider an exchange when he/she expects to acquire a replacement “like kind” property subsequent to the sale of the existing investment property. Anything other than an exchange would trigger federal and state tax liabilities at either ordinary or capital gains rates.
Some 1031 Exchange Rules
A property transaction can only qualify for a deferred tax exchange if it follows the 1031 exchange rule laid down in the US tax code and treasury regulations.
The foundation of the 1031 exchange rule is that the properties involved in the transaction must be “like kind” and both properties must be held for a productive purpose in business or trade, as an investment.
The 1031 exchange rule also lays down a guideline for the proceeds of the sale, which must go through the hands of a “qualified intermediary” or “QI.” In general, the entire cash or monetary proceeds (not just the profit) from the original sale has to be reinvested in the new (replacement) property or properties. Any cash proceeds retained from the sale may be treated as taxable income.
A second rule of a 1031 exchange requires that the replacement property be subject to an equal or greater level of debt than the debt on the relinquished property. Otherwise, the investor may owe tax on the difference in the debt.
Timelines
An investor is subject to “the identification period” in choosing a replacement property. It is not uncommon to select more than one property but there are specific limits as both to the number of properties identified and the time to identify them. After the identification period, there is “the exchange period” within which an investor who has sold the relinquished property must receive title to the replacement property. This period ends 180 days after the date on which the investor sells the relinquished property.
The 1031 exchange is a great gift from Congress and the IRS, but like all gifts from the government it comes with more strings than any property owner can keep track of. For help and more information, contact a 1031 specialist.
