When exchanging real property, most taxpayers will end up reporting a gain or a loss on their income tax. This tax, called a capital gain tax, can exceed 20-30% of your monetary or property gain, which is the purchase price minus the selling price, leaving you with severely depleted buying power when you go on to make an exchange for a different building. However, a legitimate 1031 exchange can help you evade the issue of taxable property gain entirely.
A 1031 exchange is a section under the Internal Revenue Code that allows a real property owner to sell his property and reinvest the proceeds that he obtained in the sale in ownership of “like-kind” property and avoid paying taxes on the sale.
To qualify for a “like-kind” exchange, the real property that you sell and the real property that you invest in with the proceeds must both be held for productive use in trade or business or for investment purposes.
To avoid the tax consequences on the sale, the property that must be exchanged has a specific timeline of periods that must be followed:
- Identification Period: After the sale of the original property, the investment property being replaced must be identified within 45 days of the original sale.
- Exchange Period: The taxpayer must receive the replacement or investment property being exchanged within 180 days after the date on which the taxpayer transferred the property sold.
- Cash Proceeds: The replacement property that is being exchanged must be subject to an equal or greater value of the property that is sold or the buyer will either pay taxes on the amount that he profits from. For example, if the exchanged or replacement property in $100,000 lower in price than the property sold, the buyer would have to pay taxes on the $100,000 and cannot use it as his personal gain. The taxpayer can use the excess cash on another investment property to offset the profit if he wants to avoid tax.
In a 1031 exchange, you can exchange any real property for any other real property and avoid paying taxes on the new purchase or sale if the property is held for productive use in trade or business or for investment purposes. The invested property cannot be a property for personal or residential use by the taxpayer. Some examples of “like-kind” investment properties are:
- Apartments building with tenants
- Commercial buildings
- Condos or duplexes
- Rental homes
- Unimproved land for commercial property
- Office building or hotel
1031 exchanges are governed by a strict set of rules which determine whether or not property qualifies, how the sale or exchange should take place, and what the parameters for the exchange are. These are laid out as three basic rules:
- The properties involved in the exchange must be both "like-kind" and be held for a productive purpose in trade or business, as with an investment.
- You may not deal directly with the money involved in the exchange. A qualified intermediary must be hired to handle all proceeds from the sale.
- The property intended to replace the current property must be subject to either an equal or greater level of debt than the current property. This means that you cannot exchange a greater-valued property for a lesser-valued property, or else you will be taxed on the difference.
Failing to comply with any of these rules means that you will fail to qualify for a 1031 Exchange, and thus be required to pay income tax on the sale and purchase of your properties. These kinds of taxes are also referred to as "boot".
A 1031 exchange is a deferred tax exchange meaning that it provides major tax advantages for investors who want to buy and sell property for investment and commercial purposes. The primary benefits of a 1031 exchange are:
- Deferral of taxes that allow you to sell your investment property and reinvest in a similar investment property and avoid paying tax on the sale.
- Leverage and increased cash flow for reinvestment purposes and giving you more money available to make other investments instead of paying taxes on it.
- Relief management for property owners who are burdened with extensive maintenance and intensive management. They can now reinvest in property that have lower responsibilities.
- Increase of wealth and assets without paying taxes each time a sale occurs.
If you are familiar with a 1031 exchange or "like-kind" laws, you may proceed on your own. However, tax laws are constantly fluctuating, and if you are at all uncertain about whether you qualify for a 1031 exchange, you should get in touch with a real estate lawyer who can help you to better understand your options. An attorney can also represent you in front of the IRS if you are subject to a collection process in connection with your attempt at a 1031 exchange.