1031 Exchange

A 1031 exchange or Like kind exchange is defined by section 1031 of the Internal Revenue Code. This code specifies that if an asset, usually some form of real estate such as land or a building is sold and the proceeds of the sale are then reinvested in a like kind of an asset then no gain or loss is recognized, allowing the deferment of capital gains taxes.

Details

In order to qualify certain rules must be followed. Broadly these rules are as follows:

1. Both the relinquished property and the replacement property must be held either for investment or for productive use in a trade or business. A personal residence cannot be exchanged.
2. The asset must be of like kind. Real property must be exchanged for real property. Personal property must be exchanged for personal property.
3. The proceeds of the sale must be invested in a like kind asset within 180 days of the sale; however, the property must be identified within 45 days.

This is an effective way to defer paying taxes that would otherwise have been due on the first sale, for example - an investor bought a townhouse for $200,000. He then sells the property for $250,000. This results in a gain of $50,000 and the investor would have to pay capital gains tax on this amount. However if he invests the $250,000 in another piece of residential real estate (like kind - does not have to be a townhouse), then he does not have to pay any taxes now i.e. he defers his taxes till a later date.

A 1031 Exchange is similar to a traditional IRA or 401K retirement plan. When someone sells assets in tax-deferred retirement plans, the capital gains that would otherwise be taxable are deferred until they begin to cash out of the retirement plan. The same principal holds true for tax-deferred exchanges or real estate investments. As long as the money continues to be re-invested in other real estate, the capital gains taxes can be deferred. Unlike the aforementioned retirement accounts, rental income on real estate investments will continue to be taxed as net income is realized.

How You Can Accomplish a 1031 Exchange

Once an investor has decided to pursue a 1031 Exchange, the process is fairly straightforward and will be carefully facilitated by a qualified intermediary. It is suggested that you contact a QI as soon as the exchange decision has been made. Here is a typical timeline involving an exchange, presented in the traditional order of occurrence.

1. Investor decides to sell investment property and do an exchange. Investor contacts a QI.
2. Investment property is put on the market.
3. Offer to purchase investment property is accepted.
4. Escrow for the sale is opened and preliminary title report produced.
5. The QI sends required exchange documents to escrow closer for signing at property closing.
6. Escrow closes.
7. Within the first 45 days after the close of escrow on the sale of the relinquished property, investor identifies replacement property as required by law.
8. Within 180 after the close of escrow on the sale of the relinquished property, investor closes on replacement property that was identified by them. The exchange is completed.

Frequently the most difficult component of a 1031 Exchange is identifying replacement property within the first 45 days following the sale of the relinquished property. The IRS is very strict in not allowing extensions. The only way to extend your 45 days is on the front end, and that is done by carefully thinking about your replacement property alternatives before you close on the sale of your relinquished property.

Alternative method to defer capital gain

An alternative to a 1031 Exchange for someone who does not want to continue to hold property is a structured sale.