What is a 1031 Exchange?
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged for real property of like-kind to be used either for productive use in a trade or business or for investment.
Simply put, an exchange is the sale of a business use or investment property followed by the acquisition of another linked together by paperwork and completed within the set time periods. They have been part of the tax code since 1921 and are based on the continuity of investment, encourage reinvestment and are good for the economy.
What Qualifies?
Any type of real property can be exchanged provided both the relinquished property and the replacement property are held for productive use in a trade or business or for investment. The term like-kind refers to the nature or character of the property not the specific type of property. Like-kind has a very broad and liberal definition and just about any real property will qualify except property held for sale or for personal use.
- Properties may be located anywhere within the United States (50 states or District of Columbia). Income producing property in the U.S. Virgin Islands, Guam and the Northern Mariana Islands may qualify.
- More than one property may be sold or acquired.
- Foreign property can be exchanged for other foreign property held for investment or business use.
Requirements
- Like-Kind Requirement
- Qualifying Use
- Time Periods
- Same Taxpayer
- Use of a Qualified Intermediary (QI)
- Maximizing the Deferral
- No Receipt of Exchange Funds
Time Periods
There are two time periods that must be met in a 1031 exchange and both begin with the closing of your first relinquished property. The time periods run concurrently and are based on calendar days not business days.
The 45-Day Identification Period requires the identification of like-kind replacement property. The identification must be made in writing and signed by all Exchangers. A written identification signed by your agent, such as your attorney, accountant or real estate professional, instead of you will be an invalid identification.
- At any time during this 45-Day Identification Period, a written identification may be revoked and a new one made.
- If a like-kind replacement property has not been properly identified by midnight of the 45th day, the exchange will fail and you will be unable to defer the capital gains. On the 46th day (or the next business day), all funds, including interest earnings, from the exchange account will be paid to you.
Tip: There is no way to extend the 45-Day Identification Period but you can take advantage of the time you have before the 45-Day Identification Period starts. Begin looking for your desirable replacement property before you have your relinquished property sold. You can sign an Agreement of Sale for the replacement property before conveying title of the relinquished property to a buyer. You can request to be reimbursed from the exchange proceeds for any out-of-pocket earnest money deposits made on the replacement property. The reimbursement is made at the time of acquisition of the replacement property. The dates the Agreements of Sale are signed do not matter and the time deadlines are based on the actual conveyance dates.
The 180-Day Exchange Period* runs concurrently with the 45-Day Identification Period and requires the acquisition of all desired identified replacement properties. Signing an Agreement of Sale is not sufficient. The Taxpayer must actually take legal and equitable ownership of the replacement property on or before the 180th day.
Benefits of a 1031 Exchange
While 1031 exchanges provide immediate tax deferral, the real power of exchanges are in the many short and long-term investment and business objectives they can help you accomplish. Some examples of the many benefits include:
Estate preservation as tax may be forgiven upon death and heirs receive stepped up basis
Defers capital gains, depreciation recapture and could help avoid the 3.8% Net Investment Income Tax and Alternative
Minimum Tax (AMT) so all of your other income is taxed at a lower level
Time value of deferred gain allows the deferred gain to keep appreciating
Greater buying power
Increase cash flow
Less management responsibility
Diversification of investments (types of property or their locations)
Consolidation of properties
Relocation or expansion of business
Exit strategy for business owners
Acquisition of property to eventually be converted into a personal use property
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