A 1031 Exchange is the best-kept secret in the tax code. The 1031 rules allowed owners of certain types of real property to sell their property and buy other like-kind property without paying the capital gains tax. No other section of the Internal Revenue Code allows owners of capital assets to defer the payment of taxes indefinitely.
In simple terms, section 1031 states, “No gain or loss shall be recognized on the exchange of property held for business or investment if such property is exchanged solely for property of like kind.” If you buy up in value on your next real estate purchase, you will pay no tax. If you buy down in value there is an opportunity to defer part of the capital gains tax.
There are many advantages to exchanges.
- Investment property can be transferred from one location to another. Investors who move can exchange for properties closer to home. An exchange may also be a way to buy a replacement property in a site ideal for future retirement.
- Current cash returns can be improved without sacrificing equity. Because of retirement or another lifestyle change, an investor may want a property that produces a higher monthly income instead of the property he or she currently owns that might increase in value over time. Exchanging allows an investor to swap for a property that produces a higher monthly income without incurring any current tax liability.
- Greater investment appreciation may be gained without a large tax bill. Some high-bracket investors may wish to forgo current income to accumulate future equity. Using a tax-deferred exchange makes it possible for investors to “sell high and buy low” and keep the entire profit working for them.
- Investments can be consolidated or diversified. Changes in an investor’s philosophy may necessitate real estate portfolio changes. Exchanging makes it possible for an investor to sell a group of properties and transfer the equity into one larger piece of property. It’s also a good tool to redistribute investment risk among a variety of property types and locations.
- Management hassles can be reduced or eliminated. An investment property requiring frequent and time-consuming attention may be exchanged for one requiring less hands-on management or one that is professionally managed.
The like-kind provision is quite broad and includes Land, Rental, and Business property. Any of which, can be exchanged for the other. There are some timelines that must be followed with a 1031 Exchange.
Identification Period: Within 45 days of selling the relinquished property the taxpayer 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.
The rules also require that the taxpayer uses a safe harbor to hold the proceeds while the exchange is in progress. The only practical safe harbor for taxpayers is a Qualified Intermediary (QI). A QI will assist in two major tasks, preparing your exchange agreement and escrowing your equity proceeds during the exchange.
1031 Exchanges can be a powerful investment tool. With a little planning between your tax advisor and Qualified Intermediary, the client has a great opportunity to save a substantial amount in capital gain taxes. Please feel free to call us and see if we can help you save with a 1031 exchange.