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  • Writer's pictureMike Roberts

Understanding the IRS Code 1031 Exchange

Owners of business or investment property may want to sell and reinvest in a similar new property. An IRS rule allows you to accomplish this goal while deferring capital gains taxes on the property sale through a transaction known as a “1031 exchange.” Here’s how this complex but beneficial provision of the tax code works.

What is Rule 1031?

Section 1031 of the IRS Code allows owners of a business or investment property to defer taxes when the property is sold and gains are reinvested in another similar property. Individuals, C corporations, S corporations and limited liability companies (LLCs) can all take advantage of this rule. Section 1031 requires the owner to reinvest the gain in another “like-kind” property within a prescribed time limit and according to special rules.

The benefit of the 1031 exchange is that it allows the seller to retain capital for increased investment rather than paying it out in taxes.

What property qualifies?

Both the property sold and the one to be purchased must be for business or investment use, not personal. If the newly purchased property is of lesser value, or if some cash from the sold property is held back and not used in the second purchase, the difference in values or the withheld funds is known as “boot” and are subject to taxation.

Most commercial or investment real estate exchanges will qualify as long as they don’t involve personal property. Under the tax law changes of 2017, the law can no longer be used on business property other than real estate, such as machinery, automobiles and intellectual and other intangible property. Real estate held primarily for the purpose of sale is not eligible for 1031 exchange treatment.

A vacation home might qualify under certain conditions if the intent is to regularly rent it as an investment property. A developed commercial or investment property can be exchanged for a less developed property as long as the second property will be used commercially or for investment. 1031 treatment is not available when a domestically owned property is exchanged for foreign property.

The exchange process

The simplest 1031 exchange is a straight swap of properties between owners, however, it is often difficult to find another party that would want to swap a matching property.  If one property is sold first and the proceeds of the sale are to be used later in the purchase of a second property, more complex rules apply. When selling and buying the two properties, there must be an integrated process from start to finish.

Proceeds from the first sale cannot come into possession of the seller, but must instead be held by a qualified intermediary (QI) for the purchase of the second property. A qualified intermediary, such as an attorney or real estate agent, cannot have served within the previous two years as an agent for the property owner doing the exchange. A bank or escrow agent that provides routine services only, however, is eligible to be the QI.

A like-kind property must be identified within 45 days of the sale of the first property. This must be evidenced in a document containing a detailed description of the property to be purchased and signed by both parties to the exchange. The purchase must close within 180 days of the sold property’s closing.

Get professional help

Research to find a real estate investment management company to act as your facilitator for this complex transaction. Experience is essential in these deals. The facilitator can recommend a well-qualified intermediary with whom it has worked. Be sure that the qualified intermediary has fidelity bond coverage to protect you from fraudulent behavior. Ask questions and research the facilitator and the qualified intermediary. Both should be staffed with experienced, reputable professionals who know the 1031 process thoroughly.

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