1031 Tax Deferred Exchanges - an Overview

Normally when investment property is sold, the IRS will tax any gain. The Federal Capital Gains rate is currently 15% and some states assess an additional tax as well. There is also 25% recapture rate on any depreciation taken over the length of ownership. Sellers not considering these factors can have serious tax consequences when selling investment properties. Section ?1031 of the Internal Revenue Code (IRC) provides an exception to these tax rules and is an important tool for any real estate investor.

Section ?1031 allows for deferment of the capital gains and recapture taxes, provided that certain rules and processes for exchanging are followed. This process is called a ?1031 Tax-Deferred Exchange or a ?Like-Kind? Exchange.

The Rules As mentioned, there are rules that must be followed to qualify for tax deferral using a ?1031 Exchange. A minimum of two properties must be involved in an exchange: one (or more) being sold, and one (or more) being purchased to replace it.

Not all properties qualify for an exchange: they must be held for productive use in trade or business or for investment. Qualifying properties can include rental properties, raw land, office space, and tenant in common properties. It is important to note that personal use properties, such as a primary residence, do not qualify.

The properties being exchanged do not need to be identical in nature, they just need to qualify as investment. So a piece of raw land can be exchanged for a condo, or an apartment complex could be exchanged for a Tenants in Common investment etc.

To defer all the capital gains tax, (1) the value of the replacement property must be equal to or greater than the sale?s property, and (2) all of the sales equity (cash remaining) must be reinvested. A ?1031 Exchange can still be used even if all the money will not be reinvested. Any money that is included in the exchange and used to purchase replacement property will be tax deferred and any remaining amount will be taxed. This is called a partially deferred exchange.

The most important requirement for a successful exchange is that an independent third party- called an Accommodator or Qualified Intermediary must be used. If a property is sold without a Qualified Intermediary and the proceeds are given to the seller, the IRS will assess the capital gains tax and the opportunity to defer will be lost. In a ?1031 Exchange however, the proceeds are forwarded to the QI who holds them until the client directs their use to purchase replacement property.

There are three critical timing rules. An exchange must be entered into prior to the close of the sales property so it is very important to contact the QI early on. Within 45 days of the close of sale, potential replacement property must be identified in writing with the accommodator. And within 180 days from closing of the sale, all replacement property must be purchased.

By following these guidelines with the help of a 1031 Specialist, investors have the opportunity to build wealth by reinvesting undiminished gains into their next property.

To talk with a 1031 Exchange Expert or call 866-405-1031