We get asked about so-called Section 1031 exchanges all the time. Section 1031 of the Internal Revenue Code is a valuable tool that allows you to defer payment of taxes on a gain from the sale of investment property, if you reinvest those proceeds into a new property and adhere to the code’s requirements. If done properly, real estate investors are allowed to retain the gains from their investments, and defer their capital gains tax liability (potentially forever).
Here's what you need to know:
1. 1031 Exchanges are Tax-Deferred, Not Tax-Free
When you transfer the basis from one investment property to another, you preserve the gain for recognition later. When the replacement property is eventually sold (not part of a later exchange), the original deferred gain plus any additional gain from the sale of the replacement propertyis subject to capital gains tax.
2. Taxes May Be Deferred Forever
There is no limit on the number of 1031 exchanges you can do. So, you can roll the deferred gains on an investment property over and over again, and can eventually even pass the real estate investments to your heirs. The total of all these capital gains properly accumulates, and would of course be due if you were to sell the asset during your lifetime. But if the property passes to your heirs, they receive a step-up basis (meaning that their inherited basis is the fair market value of the asset at the time of your death), and will never have to pay the accumulated gain. Depending on the amount accumulated, this method could be used to lawfully avoid paying a significant amount to the IRS.
3. Section 1031 Does Not Apply to Primary Homes
You can only use a Section 1031 for investment and business property. But it is not limited to real estate investments. It may be used for personal property, like a valuable painting, or gold coins. Certain types of property are specifically excluded from Section 1031 treatment. Examples are stock shares, equity securities in a corporation, partnership interests, and shares of trusts.
4. Exchange Must Be “Like-Kind”
Properties swapped in a 1031 must be of “like-kind,” but the definition is broad. It refers to the use of the properties. Both the old and new must be used for investment or business purposes. You don’t have to exchange an apartment building for another apartment building. You can swap for undeveloped land or an office building (or multiple buildings), as long as they are investment properties.
5. Beware of Strict Time Limits
While sometimes a 1031 exchange is a simultaneous closing on the sale and purchase, this is not required. But you must meet two strict time limits or will be required to pay taxes on your gain:
- Within 45 days of the date you sell your property, you must identify potential replacement properties in writing to the qualified intermediary who is holding the proceeds from the sale of the old property; and
- You must complete the replacement property exchange transaction (that is the closing on the purchase) no more than 180 days after the sale of the exchanged property, or the due date (with extensions) of the income tax return for the tax year in which your relinquished property was sold, whichever is earlier.
6. You Cannot Touch the Cash From the Sale of Your Property
Taking control of the proceeds from your asset sale before the exchange is complete will likely disqualify the entire transaction and make the gain immediately taxable. The best way to avoid the receipt of proceeds is to use a qualified intermediary to hold those proceeds until the exchange is complete.
7. Size Matters
The size or value of the investment in the replacement property must equal or exceed the net proceeds received from the sale of the property you give up. Any net proceeds you receive that are not reinvested are treated as capital gain for tax purposes. The value of liabilities you assume with the replacement property, such as amount of the mortgage on the replacement property, must equal or exceed the value of the liabilities you relieve yourself of when you dispose of your old property.
8. You May Name Multiple Replacement Properties
IRS rules allow you to name more than one replacement property. You may name up to three properties, without regard to their fair market value, so long as you close on one of them within the 180-day time period. Alternatively, you can name any number of properties as long as their fair market value at the end of the identification period does not exceed 200% of the fair market value of the old property as of the transfer date.
The 1031 Exchange has been described as the most powerful wealth-building tool still available to taxpayers. Given that capital gains taxes typically run between 15% and 30%, it is easy to see why its use has been a major part of the success strategy of numerous investors. If you have questions about this for a real estate attorney, or about any other aspect the buying or selling process, contact us.
