1031 Exchange is one of the most preferred investment vehicle to defer capital gains, state, and income taxes on the sale of a real estate property, held for investment or business purposes. However, the IRS has laid out a complex set of guidelines to ensure that this feature is not misused for tax fraud.
1031 Exchange Basics
IRS Code 1031 governs 1031 Exchange transactions which allow a taxpayer to defer taxes by re-investing the gains from the sale of an investment property into a suitable like-kind property.
Section (1031(a)1 states that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or investment if the property is exchanged solely for property of a like-kind that is to be held either for active use in a business or for investment purposes.”
As per the IRS, the below-mentioned guidelines need to be followed to qualify for a tax-deferred exchange transaction successfully.
Timelines: Time frames are critical in a 1031 Exchange transaction. An exchanger gets a maximum of 45 days from the sale of the relinquished property to identify a like-kind real estate that is equivalent in value or higher. The properties identified during these 45 day identification period must be acquired within the next 135 days. In total, an exchanger has 180 days starting from the day of the sale of the relinquished property. They need to identify a like-kind property within the first 45 days and acquire the replacement property in the next 135 days. Most of the exchange transactions which gets disqualified by IRS is because of investors failing to either identify or acquire replacement property within the stipulated time period.
Like-Kind Property: A suitable replacement property for a 1031 tax-deferred exchange should be “like-kind” to the relinquished real estate. Like-kind implies “similar in nature or character, regardless of any disparity in grade or quality. IRS will only pass a property as “like-kind” if they are actively engaged in a trade or business or held for investment purposes. A 1031 exchange can include any of the following property types:
Delaware Statutory Trust
Retail Shopping Centers
Triple Net Leases
Single Family Homes
There are a few necessary restrictions around like-kind properties.
• Primary residences will not be viewed as an investment property for a 1031 Exchange.
• Any property purchased or sold with the purpose of a “fix and flip” is not suitable for a 1031 exchange.
• The like-kind property needs to be located within the United States. For example, a seller cannot use the proceeds from selling a property in the U.S. to buy a property in Australia and expect to defer capital gains on the sale.
• Stocks, Partnership interests, securities, and other financial assets are omitted from the definition of like-kind property.
Equal or Greater Debt and Equity in a 1031 Exchange: If the exchanger trades a property for $2 million, in which $1500,000 was equity, and $500,000 was debt, then the exchanger must purchase $2 million or more worth of property. Also, the exchanger should use all the equity and replace the entire debt to enjoy 100% deferral of the capital gains taxes.
Under 1031(d), as mentioned on the IRS website, the basis of property acquired in a 1031 exchange is the same as the basis of the property exchanged, decreased by any money the taxpayer gets, and increased by any gain the taxpayer recognizes.
Role of a Qualified Intermediary for a 1031 Exchange: A Qualified Intermediary (QI) is essential for the successful completion of a 1031 Exchange. The Qualified Intermediary starts with a written agreement with the taxpayer stating they are liable for assigning the relinquished property to the buyer and further assigns the replacement property to the taxpayer after the 1031 Exchange agreement. QI’s secure the gains after the sale of the relinquished property in an escrow account to ensure that the Taxpayer never gets an actual or constructive receipt of the sale proceeds.
A Qualified Intermediary is responsible for completing the following activities in a 1031 Exchange:
• Procuring the Relinquished Real Estate Property from the taxpayer himself.
• Assigning the Relinquished Real Estate Property to the buyer himself.
• Acquiring the Replacement Real Estate Property from the seller himself.
• Transferring the Replacement Real Estate Property to the taxpayer himself.
Engage our services for a profitable 1031 Exchange and Defer Capital Gain Taxes:
1031 Exchange allows tax deferral and maximizes your profits. However, the exchange guidelines need to be followed thoroughly to ensure that the IRS does not disqualify your transaction. We have more than 15 years of experience in handling highly profitable exchanges for our varied client base.
If you are looking to complete a 1031 Exchange and searching suitable properties, feel free to contact us. We have more than 15 years of experience managing highly profitable exchange for our investors. We have access to suitable off-market premium-grade properties ideal for 1031 Exchange. To obtain a FREE PROPERTY LIST, click here.