What is a 1031 Tax Exchange

If you have experienced large appreciation in your real estate investment and you are planning on selling it, you need to become familiar with a "1031 Exchange". We are not accountants and cannot offer tax advice. However, TIMCOR Exchange Corporation performs over 7000 exchanges for clients each year throughout the country. Jeff Johnston is a Marketing Executive with TIMCOR and he provided us with information for this article.

Normally when you sell property, the IRS will tax your gain. The federal capital gains rate is 15% and some states will take an additional tax bite. Section §1031 of the Internal Revenue Code (IRC), however, provides an exception to that general rule. It allows the deferment of your capital gains tax liability, provided that certain rules are met and that you follow a certain process for exchanging. It is referred to as a "1031 Tax-Deferred Exchange".

1031 Exchange Rules

You need to have at least two properties in your exchange: one (or more) that you are selling, and one (or more) that you are replacing it with.

Not all properties qualify for an exchange: they must be held for productive use in a trade or business or for investment (e.g. raw land, rental apartments, office buildings, warehouses, industrial, retail). Importantly, properties held for personal use, such as one´s personal residence or vacation home, do not qualify.

The properties that you are exchanging do not have to be identical in nature. They just need to qualify as real property. You can exchange a piece of raw land for a rental condo in Myrtle Beach, for instance, or sell a 2 bedroom rental condo and replace it with a 3 bedroom rental house or sell an apartment building and replace it with a warehouse, etc.

To defer all of your capital gains tax, (1) the value of the replacement property must be equal to or greater than the sales property, and (2) all of the sales equity (cash remaining) must be reinvested. If you are unable to reinvest all of your sales proceeds, you still may do a 1031 exchange. But just remember that any funds that are not reinvested are liable for tax.

The most important requirement for a successful exchange is that YOU CANNOT TOUCH THE MONEY. An independent middleman ? often call an Accommodator or Qualified Intermediary (QI) ? MUST be used. If you sell a property and touch the sales proceeds, the IRS will tax you. In a 1031 exchange, however, rather than you receiving the sales proceeds, the accommodator receives it. The accommodator holds that money on your behalf until that time when you direct it to be sent towards payment of your replacement property.

Working with the assistance of a REALTORŽ (Brad Bergamini) you identify what to sell and buy. But, the accommodator  is the legal vehicle through which the properties are transferred.

Keep in mind these three critical timing rules. An exchange must be entered into prior to closing on the sales property. Within 45 days from this date of closing, the potential replacement property must be identified. And, within 180 days from this sales closing, the replacement property must be closed.

Like-Kind Exchanges - Real Estate Tax Tips

 

Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.

Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.

Like-Kind Property

Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. However, livestock of different sexes are not like-kind properties. Also, personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties.

Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.

Additional Resources

Note: This page contains one or more references to the Internal Revenue Code (IRC), Treasury Regulations, court cases, or other official tax guidance. References to these legal authorities are included for the convenience of those who would like to read the technical reference material. To access the applicable IRC sections, Treasury Regulations, or other official tax guidance, visit the Tax Code, Regulations, and Official Guidance page. To access any Tax Court case opinions issued after September 24, 1995, visit the Opinions Search page of the United States Tax Court.