A 1031 exchange is an excellent tool available to owners of investment real estate. Section 1031 of the Internal Revenue Code states, in effect, that upon the sale of an investment property or real property used in a trade or business, the owner can use the funds from the sold property to purchase a similar, or "like-kind" property, and thus not be liable for capital gains taxes on the proceeds from the initial property. To complete a 1031 exchange, there are some basic rules that must be followed, however there are many benefits of this type of exchange.
More to Invest. Federal income taxes are deferred, the exchanger has greater leverage than if the tax liability was paid. The additional equity available for the reinvestment can also assist the exchanger in obtaining more financing, if needed.
Greater Earning Potential. Since more of the capital is reinvested than would be the case if taxes were paid, there is potential for greater earnings for the investor.
Compounding Effect. Exchange after exchange can be done creating a positive compounding effect of reinvesting the additional deferred taxes on each subsequent exchange. The deferred tax liability can ultimately be forgiven upon death of the investor, giving heirs a stepped up basis on inherited property. Pricing Flexibility. The investor can experience greater pricing flexibility because the sale price of the relinquished property will not need to be inflated to cover capital gains taxes. This enables the seller to have increased flexibility with the selling price.
Learn more about a 1301 Exchange with this list of Frequently Asked Questions.
What is a like-kind exchange?
A like-kind exchange, also known as a 1031 Exchange, is a technique for deferring the gain on the sale of property by re-investing the proceeds in like-kind property.
What is the primary benefit of a Deferred Exchange?
The primary benefit for owners disposing of business or investment held property is the opportunity to defer the payment of Capital Gains Tax.
When was the idea of a 1031 Exchange developed?
In 1921 the first exchange laws were enacted. Changes have been made, but it wasn't until 1991 when the Regulations were made available that this concept of dispositions has become very popular. The theory is that if one does not cash out of an investment, the economic gain has not been realized in a way that produces the cash to pay the tax.
Can I acquire more than one piece of property?
You can come out of one relinquished property and acquire any number of 1031 replacement properties. As long as the value that you sell is at least the value you purchase, there will not be a taxable event.
What is the term trading up?
It is adding money to an exchange and acquiring an even more expensive piece of property than you sold. Or, you can increase your debt, but you must use all of the proceeds from the relinquished property as well.
Can I use part of the cash from the transaction for other means and use the remaining proceeds to do a real estate exchange?
Yes, but the cash will be subject to taxation. This is called a partial exchange.
Can I add an additional investor in the new piece of property I am acquiring?
Yes, but he must be an Investor and not a partner.
What is a deferred/delayed Exchange?
You surrender your relinquished property at one time and acquire the new 1031 replacement property, no later than 180 days from the closing of the relinquished property, or the due date for the tax return for the year of the sale, whichever is earlier.
How much time do I have?
You will have 45 days from the day you close your relinquished property (escrow) to identify the candidate(s) you wish to acquire, this is known as the Identification Period. You will then have an additional 135 days in which to close your replacement property purchase. You cannot exceed the maximum 180-day period for the exchange to take place. This is known as the Exchange Period. The IRS has absolutely no forgiveness for missed time deadlines for any reason.
Will I ever have to pay taxes on the property?
Only when you finally sell the property you exchanged into, without doing another exchange. You can continue to roll over sold properties into new properties without any tax obligation.
Can I build on property I already own?
Not with deferred tax dollars.
Can I use a Build to Suit Exchange as a replacement property?
Yes, but you must take title within 180 days.
How will this affect my Estate Planning?
If you hold the exchanged property until death, your heirs receive a stepped up basis to fair market value, and the capital gain is never taxed. Which means the income taxes that were deferred by you now become permanently tax-free to your heirs.
If I want to use a 1031 Exchange, but my co-owner wants to cash out and take his money, is that allowed?
Yes, however, his portion will be subjected to the tax on any profit/gain. Partnership interests cannot be used as exchanges.
Can I exchange my property for a property in another state?
Yes, anywhere in the U.S.A.
What types of real estate qualify for a 1031 Exchange?
Vacant land, office building, warehouse, apartment building, mini-storage, motel/hotel, farm/ranch, rental house, rental condo, resort rental, shopping center, owner-occupied double/duplex.
Plus: any other commercial, industrial, business, or investment-held property. The only provision where 1031 exchanges don't qualify is when you are a dealer in real estate. This simply means that if a person or corporation acquires property with the intent of a fast re-sale, then the transaction won't qualify. The IRS has limited exchanges to those properties held for productive use in a trade or business or for investment, and necessarily excludes those held primarily for sale.
What are the requirements to do a 1031 Deferred Exchange?
The seller must dispose of either business- or investment-held property. The seller must acquire other business- or investment-held property of equal or greater value than the value (sale price) and existing debt of the property being sold, and all of the equity from the property being sold must go into acquiring the replacement property.
Can I trade out several smaller properties for a larger one?
Yes, as long as the value of the properties are equal.
Why does our government allow Deferred Exchanges?
The government perceives it as a continuity of investment.
Is a Partially Taxable Exchange possible?
Yes, you acquire with part of the funds, and you pay taxes on the balance of the funds.
Can I refinance my old or new property before or after I have made an Exchange?
Yes, the benefit is that the proceeds from financing or re-financing are tax-free.
Can I hold a mortgage on my relinquished property and still have an exchange performed?
Yes, the mortgage payment received is considered an installment sale and is subject to taxation as deemed received. The balance of the taxpayer's equity can be used as a deferred exchange.
Is a Leasehold Interest considered like-kind?
Yes, leasehold interest may be either relinquished property or replacement property in an exchange as long as there are 30 or more years remaining on the lease.
What happens with a failed exchange?
If a taxpayer executing an exchange does not acquire a replacement property and the exchange period straddles two tax years, the transaction becomes an installment sale and is taxable in the subsequent year.
Can I have an Exchange performed on personal property?
Yes, 1031's pertain to personal properties too. Some examples would common: equipment, furniture, aircraft, vehicles, vessels, livestock, and coins.
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