What is a 1031 Exchange?
When you sell a property you typically have to pay tax on the gain. Gain is created when the property appreciates in value during its ownership or when deductions for depreciation are taken for tax purposes.
A Section 1031 tax deferred exchange, named for the Internal Revenue Code Section it refers to (also known as a Starker Exchange, Tax Free Exchange, or Like-Kind exchange), allows an exception to the capital gains tax. When you sell your business or investment real estate, replace it with a different business or investment property, and complete an exchange, you can defer payment of the capital gains tax normally required on these sales.
If your plans include using the money from the sale of a business or investment property to buy more of the same, a 1031 Exchange provides greater proceeds for your next investment-more than you could gain through the re-investment of after-tax proceeds.
A 1031 Exchange is not a tax loophole. It is a section of the Internal Revenue Code, written by Congress, to allow anyone who meets all the requirements to sell their property and defer paying taxes on the gain. Section 1031(a) of the Internal Revenue Code (26 U.S.C. § 1031) states the recognition rules for realized gains (or losses) that arise as a result of an exchange of like-kind property held for productive use in trade or business or for investment. It states that none of the realized gain or loss will be recognized at the time of the exchange.
Understanding an Exchange
There are 6 basic tenets of a 1031 exchange:
- All relinquished (old) and replacement (new) property must be vacant land, rental property or property used for trade, business or investment. If the properties meet these requirements, you may exchange any real estate for any other type of real estate.
- You cannot have actual or constructive control of any of the proceeds received from the sale of the old property. By law, all money is held by a Qualified Intermediary (also referred to as an Accommodator or Facilitator). You cannot have an associate or employee, your attorney, broker or CPA hold the proceeds, nor can you leave the proceeds in escrow until the second property is purchased.
- You have 45 days from the date of closing on the old property to identify a list of properties, from which you will purchase the new property.
- From the date of closing, you have 180 days to close on one or more of the properties from your 45-day list.
- The titleholder on the old property must be the same titleholder on the new property.
- You must reinvest all cash proceeds from the sale, and purchase a new property or properties of equal or greater value, in order to avoid taxation on the gains.