If you are a real estate investor and are interested in using the proceeds of the sale of one of your properties to purchase another, the 1031 exchange may be the perfect venue for you to use. In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain
is deferred until some future date.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business,
or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes
on the transaction.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax. |
To ensure your exchange goes as smoothly as possible
here are some good DO’S AND DON’T |
| DO: Advanced planning for the exchange. Talk to your accountant, attorney, broker, lender and Qualified Intermediary. As a realtor I cannot provide advice regarding specific tax consequences. |
| DON’T: Miss your identification and exchange deadlines. Failure to identify within the 45 day identification period or failure to acquire replacement property within the 180 day exchange period will disqualify the entire exchange. Reputable Qualified Intermediaries will not act on backdated or late identifications. |
| DO: Keep in mind these three basic rules to qualify for complete tax deferral: |
| 1. Use all proceeds from the relinquished property for purchasing the |
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replacement property. |
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| 2. Make sure the debt on the replacement property is equal to or greater |
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than the debt on the relinquished property. (Exception: A reduction in
debt can be offset with additional cash; however, a reduction in equity cannot be offset by increasing debt.) |
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| 3. Receive only "like-kind" replacement property. |
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| DON’T: Plan to sell and invest the proceeds in property you already own. Funds applied toward property already owned purchase " goods and services," not "like-kind" property. |
DO: Attempt to sell before you purchase. Occasionally Exchangers find the ideal replacement property before a buyer is found for the relinquished property. If this situation occurs, a reverse exchange (buying before selling) may be necessary. While
the IRS has recently provided guidance for reverse exchanges in Revenue Procedure 200-37, Exchangers should be aware that reverse exchanges are considered a more aggressive exchange variation because some other entity must hold title to either the Exchanger's relinquished or replacement property for up to 180 days pending the completion of the exchange transaction. |
| DON’T: Dissolve partnerships or change the manner of holding title during the exchange. A change in the Exchanger's legal relationship with the property may jeopardize the exchange. |
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