What is a 1031 Exchange?

A 1031 Exchange refers to a section in the Internal Revenue Code (namely, Section 1031) that is of particular interest to Realtors, Title companies and Investors. Basically, a 1031 Exchange is a mechanism by which one investment asset (such as real estate, stocks, bonds, machinery or equipment) can be swapped for another similar asset.

After selling an investment property the investor typically pays between 15% and 20% in State and Federal taxes on any financial gains from the sale. The tax liabilities may be even more substantial depending on how the transaction was structured.

In cases where an investor is selling property and using the proceeds of the sale to buy another investment property, performing this transaction as a 1031 Exchange allows him or her to defer all capital gains tax.

Rules of a 1031 Exchange

There are several rules and legal requirements to doing a 1031 Exchange:

  • Any investment property involved in a 1031 Exchange that is considered depreciable for tax purposes (these tend to be long-term assets such as vehicles, real estate, computers, office equipment, machinery and heavy equipment) automatically falls under the ‘Depreciation Recapture’ which is taxed as ordinary income.

    Depreciation Recapture can usually be avoided by swapping like-kind assets, for example one property for another similar property or one vehicle for another similar vehicle. But, for example, if you swap 5 acres of land with a building for 5 acres with no building, then all the depreciation tax deductions claimed over the years on your 5 acres with building will be recaptured as ordinary income.
  • Both the replacement and relinquished properties in a 1031 Exchanges must be investment properties – you cannot swap your primary residence under section 1031. An investment property is any building or piece of land that is held for productive use in a trade or business or kept for investment purposes.
  • The assets involved in a 1031 Exchange must be like-kind. As far as real estate is concerned, all types of property, developed and undeveloped, are considered like-kind and qualify under Section 1031.
  • The purchase price of the replacement property has to be equal to or greater than the net sales price of the relinquished property.
  • All the cash and/or proceeds gained from the sale of the relinquished property will be taxed as capital gains.

1031 Exchange Timeline

Most 1031 Exchanges are not a simple case of two parties swapping properties – in the real world the vast majority of 1031 exchanges involve a third party who acts as an intermediary to facilitate the swap. This this known as a delayed exchange.

After you relinquish your property and the intermediary sells it, you must designate a replacement property within 45 days. The details of this replacement property has to be specified, in writing, to the intermediary. Only when a replacement property is designated can the 1031 Exchange proceed to the next step.

You must then close on the replacement property within 180 days of the intermediary sells your relinquished property. Note that the 45 day limit mentioned above runs concurrently with this 180 day deadline. For example, if you designate a replacement property on the 45th day after the intermediary sells your relinquished property, then you will have (180 - 45) exactly 135 days remaining to close on replacement property.

Thinking of structuring a 1031 Exchange? We can make it happen!

Although 1031 Exchanges can be complicated to set up and execute, it is an effective method of postponing or even eliminating capital gains taxes on the sale of properties.

Call today to learn more. We work with a close network of 1031 specialists and intermediaries who can help structure the best possible deal to help you get the most out of your investment dollar!

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