Definitions and Tax Rules
To understand what a 1031 Exchange is, it is crucial to understand where the name originates from, as well as, the tax definitions and rules supporting the exchange. According to the Internal Revenue Service (“IRS”), the Internal Revenue Code (IRC) Section 1031 provides an exception for taxpayers who have sold a property at a gain. This tax rule is intended for use on investment or business properties. The 1031 tax break exchange is only allowable to personal residences after certain circumstances are met. Primary residences typically have other allowable tax breaks on capital gains taxes. After the sale of an asset (a property in this case) a taxpayer would normally be required to pay capital gains taxes on the sale. Capital Gains Taxes are the taxes owed from the profit of a sale of assets. If an asset is held for less than a year after it is purchased and is then sold at a profit, those gains are typically added to the taxpayer’s income. But if an asset is held for over a year, the ‘Long Term Capital Gains” tax rate is applicable. The percentage of capital gains owed per sale is dependent on the tax bracket of the taxpayer. The current rates range from 0% to 20% depending on income.
IRC Section 1031 allows taxpayers to postpone paying capital gains taxes on the sale of a real estate property by allowing taxpayers to roll over the taxes on the gain if the proceeds are reinvested in a similar property as part of a “Like-Kind Exchange”. A Like-Kind Exchange is an exchange of real estate property that is of similar nature that can be traded without incurring tax liabilities. The Internal Revenue’s rules around Like-Kind properties of similar nature are very liberal. The properties in the exchange do not need to be the same type of property. The only pertinent rule is that the properties be used for business or investment purposes. Personal residences are not eligible to be qualified as like-kind properties and can only benefit from Section 1031 when they meet specific requirements. Properties taking part in a 1031 exhange must also be held in the United States to qualify.
What Is A 1031 Exchange?
In layman’s terms, a 1031 exchange is a tax break. It allows for investors to swap investment properties without having to pay taxes at the time of exchange. It grants taxpayers the ability to grow their investment without having to pay capital gains taxes until an investment is liquidated or sold for cash. There is no limit to how frequently taxpayers are able to take part in 1031 exchanges. Taxpayers can defer these capital gains taxes and rollover the gains for years.
Key Timeline Regulations Of A 1031 Exchange
Most 1031 exchanges are delayed exchanges. Typically, property owners are not able to find a property to exchange at the moment of a sale. There are rules established to define delayed exchanges. Two key rules must be observed for every delayed exchange. The 45 Day Rule states that within 45 days of the sale of a property, a replacement property must be designated in writing to an intermediary. A Qualified Intermediary , sometimes referred to as an ‘exchange facilitator” or an “exchange accommodator”, must be appointed to hold the gains after the sale of a property for the sale to be recognized as a 1031 exchange. The intermediary is usually appointed by the seller and acts as a third party to hold funds and can also coordinate transfers, assist with paperwork, and support investors. There are no definitive rules on who can act as an intermediary. There are, however, rules on disqualifications for intermediaries. An intermediary must be neutral and not be directly related to any of the parties involved. Disqualified parties include family members, friends, anyone who has acted as an agent for the parties, tax preparers, etc. Investors are allowed to designate up to three properties to the intermediary as long as one of the properties is eventually closed on. The 180 Day Rule states that a property must be closed on within 180 days of the sale of the old property. Both the 45-day rule as well as the 180-day rule run simultaneously. This means that the clock begins to move for both of these rules once the sale of the property closes.
What Are The Pros And Cons of A 1031 Exchange?
Typically, if an investor is looking to purchase a new property soon after the sale of a property, a 1031 exchange is recommended. There are many reasons why an investor would be looking to carry out a 1031 exchange. The obvious pro is deferring capital gains taxes on the sale of a property. A 1031 exchange also allows for investors who are interested in moving to a new market to move seamlessly. There are no distance limitations for a 1031 exchange. There are also no limits to how often you can take part in a 1031 exchange. This means that an investor can sell a property anywhere in the United States and use the money from that sale to purchase another similar property anywhere else in the United States. It gives investors the opportunity to switch markets without having to pay major taxes.
There are, however, some cons to keep in mind. In order to move forward with a 1031 exchange, the capital gains earned on the sale of a property must be rolled over to a ‘like-kind’ investment. Should an investor want to use the gains for any other type of investment or purchase, they would lose the protection of the 1031 exchange and be required to pay the applicable taxes. Another con is that the structure can become complicated if there are multiple investors in a property and they are not all in agreement. It is possible to complete a 1031 exchange if not all of the investors of a property agree to rollover the gains. The remaining funds would be placed into a separate account and be liquidated. This circumstance is not common and is more complex.
Overall, a 1031 exchange is a great tool for investors. The Internal Revenue Service allows for investors to get a tax break and roll over their tax liabilities on the capital gains taxes potentially forever. It is a great way for investors to maximize their opportunities and build generational wealth.
It should be noted that I am not your lawyer (unless you have presently retained my services through a retainer agreement). This post is not intended as legal advice, it is purely educational and informational, and no attorney-client relationship shall result after reading it. Please consult your own attorney for legal advice. If you do not have one and would like to retain my legal services, please contact me using the contact information listed above.
All information and references made to laws, rules, regulations, and advisory opinions were accurate based on the law as it existed at this time, but laws are constantly evolving. Please contact me to be sure that the law which will govern your business is current. Thank you.