What is a 1031 Exchange

The IRS Tax Code

In the U.S., the IRS Tax Code has devised a capital gains tax-exempt option for real estate owners. This is known as the 1031 exchange. The option permits the owner to sell a real estate property but quickly purchase another without being subject to capital gains taxes on the proceeds from the sale. This is the Section 1031 of the IRS Tax Code. The seller or the exchanger of the property, to qualify as a tax-free 1031 exchanger must follow certain rules and procedures.
Profitable Savings and Benefits

Avoiding capital gains tax can be crucial to remain profitable for individuals and businesses that trade in investment properties. Basically, a 1031 exchange provides a tax-free real estate transaction from capital gains. These individuals can save the percentage of the capital gains tax that can vary from state to state, from 20 to 30 percent of the total amount.  A straight sale is only limited to 70 to 80 percent of the proceeds of the sale after capital gains tax are withheld while the 1031 exchange allows the exchanger to purchase a new property of the same value.

A Time Frame Sensitive Rule

In qualifying for a 1031 exchange transaction, there are strict time limits that must be followed. The exchanger is only given 45 days to identify a new property after the sale of a property. Moreover, the exchanger has 180 days from the date of sale to purchase the identified property. This means, within the first 45 days of the 180 days, the exchanger has to identify the property it intends to buy, and has the remaining 135 days to purchase the property. The law provides no extension on these timeframes. The days are also counted to include weekends and holidays and is based on calendar days.

Like-Kind Property Exchange Rule

The rule of a 1031 exchange transactions applies only to commercial or investment properties and not to personal residences. The like-kind property rule applies to transactions like apartment buildings and office complex structures. The properties sold and the properties purchased must of the same qualifying type. That is why the 1031 exchange rule is sometimes called the like-kind exchange rule.

The Catching Debt Requirement Rule

The purchased property, if mortgaged or financed, must be encumbered by the same amount of debt as the sold property. If the purchased property has a lower debt than the sold property, it will be considered a partial 1031 exchange. The exchange will be subject to capital gains tax for the difference.

The Rule on Qualified Intermediaries

If the exchanger handles the proceeds from the sale at any point in the process, the 1031 exchange will be considered invalid. It is considered a constructive receipt even if the money is only in the exchanger’s possession temporarily in the process of acquiring the new property. The owner will be subject to capital gains tax on that sale.

A Qualified Intermediary (QI) must be used to facilitate a proper 1031 exchange transaction. The QI shall always be an independent third party and not affiliated in any away with you, your attorney, accountant or such other agents. It is the responsibility of the QI in 1031 exchanges, to hold the proceeds from the sale temporarily and disburses the money only to purchase the chosen new property on time.

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