What Is A 1031 Exchange?

Answer:
A 1031 exchange is also known as a tax deferred exchange.

It a tax deferment strategy that is used when buying and selling investment property for the purpose of postponing the tax bill on the profits. This is a relatively simple and straightforward method for selling one investment property that’s qualified, and then moving forward with the purchase of another qualified property within a specified time frame.

The process of selling one property and buying another is identical to any typical sale and purchase, but a 1031 exchange is different in that the entire transaction is treated like and exchange instead of like a simple sale. The process of the exchange allows the taxpayer to qualify the gain for deferred tax treatment with the Internal Revenue Service. In its most basic form, sales will be taxable with the IRS, whereas 1031 exchanges will not be.

Because the IRS allows this method for deferring capital gains taxes, it is important that you understand how it works before you try to use it. The tax code for successfully using this exchange method for buying and selling property can be found within Section 1031 of the Internal Revenue Code. The specific interpretation of this code, as well as the standards of practices, rules, and compliance for a qualified transaction can be found in the publication, Like-Kind Exchange Regulations, which was issued by the United States Department of the Treasury. One thing to keep in mind is that the regulations are not simply the law, but rather, they are the interpretation of the Section 1031, and interpretations can change over time.

An investor in real estate should consider a 1031 exchange when they expect to acquire a replacement property of the same type that is subsequent to the sale of existing investment property. If you do not do this, profits on the sale of the property will be subject to capital gains taxes, which can constitute 20-30% of the gain depending on the state in which you live. When not using a 1031 exchange, you buying power is only 70-80% of what it would be when you use a 1031 exchange.

There are two main rules to follow when using a 1031 exchange. First, the total purchase price of the new “like kind” property must either be equal to or greater than the total net sales price of the property you are selling. Second, all equity that is received from the sale must be used to acquire the new “like kind” property. If these rules are not followed, it may or may not void the tax deferred status of the transaction. For example, taxes will be owed on any equity not moved into the new property. For example, if you keep $10,000 out of the in-kind transaction, there will be capital gains taxes due on the $10,000 you kept out of the transaction.

The foundation of the IRS 1031 exchange rule is that both properties involved in the transaction must be “like kind” and that both properties must be held in a productive purpose in business, such as a rental property or other investment.

An additional requirement is that the money cannot pass through the investor’s hands or his agent’s. The proceeds from the sale must go through a qualified intermediary (QI), or the transaction will become taxable. Another requirement is that the new property must end up with and equal or greater amount of debt than the old property, or the investor will be forced to pay taxes on the amount of decreased debt.

The Identification Period is the period of time in which the investor must identify other new properties they are interested in purchasing. This time period is 45 days from the sale of the property. The Exchange Period is 180 days long, and it marks the time from the sale that they must close on the new property.