Internal Revenue Service tax code 1031 relates to real estate exchanges, allowing investors to defer capital gain tax payments on the sale of the property by reinvesting the proceeds into another business or investment. It is one of the most underutilized sections of the tax code, even though it offers many benefits to investors who take advantage of it.
The “1031” comes from federal tax code related to the exchange of property held for productive use or investment. It states, “No gain or loss shall be recognized on the exchange or property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”
One issue that may hold investors back from taking advantage of 1031 Exchanges could be the misnomer “exchange.” A 1031 Exchange is more of a rollover than an exchange, and sellers can rollover gain and postpone taxes an unlimited number of times. By doing this, investors can postpone tax payments, but could also ultimately make them disappear. This can happen when a seller reinvests gain and then eventually moves into one of their investment properties and use it as a primary residence. Under the right parameters, including residing in the property for at least two years, investors can exempt $500,000.00 of taxes.
While IRS regulations are often complex and mired with intricate language and tangled requirements, you can gain a good overview of 1031 exchanges here, and, when you understand the benefits, you’ll see that it is clearly something a wise investor should know about and consider.
The property being sold and the new investment property must be “like kind.” This relates to the use of the property, and it excludes property strictly held for resale. Developers who “flip” properties won’t qualify under 1031 because their intention is to resell and not invest. Primary residences are also excluded from 1031 exchanges because a 1031 investment isn’t for personal use. Investment properties can always be exchanged for other investment properties, or for vacant land held for investment purposes, however.
The official language of the tax law is ‘like-kind,” but it’s important to keep in mind that in terms of 1031 Exchanges, like-kind is a broad term. While investors do have to have the same intentions for use, meaning the property is being held as an investment, or used for a business, the actual properties involved don’t have to be similar. Investors can exchange a strip-mall ranch for undeveloped land, or an apartment building for a strip-mall ranch, or any combination that falls within the rules and guidelines of the law.
Multiple Replacement Properties
It’s not always easy for an investor to line up a replacement property, but the IRS allows investors to name three potential properties, as long as one will eventually be closed on. There are other parameters that allow for even more properties to be designated if needed.
There are time limits here to consider. The new investment must be identified within 45 days of the closing sale of the old property according to IRS requirements, even if the 45th day falls on a holiday. Extensions are not allowed under any circumstances.
The purchase and closing of one or more of the new properties must occur by the 180th day of the closing of the old property. The closing has to include one of more properties that were listed within the 45-day time limit. Again, there are no extensions and the 180th day is firm, closing has to pass before it even if it falls on a holiday.
A Qualified Intermediary
In addition, 1031s require the use of a qualified intermediary by law. An independent third party, or exchange partner, must hold the proceeds of the sale in a separate account until the purchase of a new property is complete. This requirement protects investors by handling funds from the original sale through the exchange process. In the end, the exchange partner will deliver the money to the closing agent. Carefully considering the choice of a qualified intermediary means the investor will be in the hands of someone who knows the intricate details of the tax law, and has the experience and expertise necessary to review the process and catch any problems that may arise.
Equal or Greater Value
Investors who want to defer 100% of the capital gains tax need to make sure that the new property is of equal or greater value than the property being sold, and all of the cash profits must be reinvested.
In addition, the taxpayer listed on the old property must be identical to the one listed on the new property.
Deferred Depreciation Recapture
If investors don’t immediately need the depreciation deduction on a property, a 1031 will allow them to defer it to a time when they actually need to use it against taxable income.
Investors can’t hold both the old and new property title in their name at the same time and qualify for a reverse exchange, however, the IRS allows the title of a new property to be held by an outside entity until the old property is sold.
1031 exchanges can protect investors from capital gains taxes. They are also a way for investors to successfully grow their portfolios and see increased returns on their investments. But it is important to note that they are complex deals in nature because the tax code has many intricate details. Therefore it is best to work with a partner who has thorough knowledge of both the exchange process and who knows how to navigate the process seamlessly.