What is a 1031 Exchange?
The 1031 Exchange refers to section 1031 of the U.S. tax code. In essence, the code states that an individual may swap one business or real estate investment for another, while deferring the tax on the capital gains realized from the sale of his property. This, in effect, allows your investment to grow tax deferred. There is no limit as to the number of times an individual may use the 1031 formula. One can, therefore, keep rolling over their investments with no time limits. You would only be liable for the capital gains tax when you finally sell for cash, possibly years in the future. The final benefit is that when you do cash in, you’ll only have to pay one tax – and that would be at the long-term capital gains rate of only 15%.
Here are some of the finer points that the investor needs to know before utilizing this tax benefit:
- A 1031 isn’t for personal use. It is for investment and business property only. No, you can’t swap your home for another one and reap the benefit.
- Exchanges must be of “like kind.” But this does not mean what it seems to suggest. The rules are delightfully lenient. You can, for example, exchange an apartment building for undeveloped land, a strip mall, or a factory.
- You can delay the exchange. If, for example, you don’t find a property quickly that you want to exchange for, a third party (middleman) may be used to hold the cash that you received from the sale of your property, and then use it to purchase a suitable property for you.
- In a delayed exchange, once the sale of your property occurs, the middleman will receive the cash. Within 45 days of the sale, you must designate a replacement property in writing to the intermediary, specifically designating the property you wish to purchase.
- The IRS stipulates that you can designate up to three replacement properties, but you must close on one of them.
- You must close within six months. The clock begins to tick the moment your property closes.
- If you have cash left over after the exchange is complete, it will be taxed as capital gains.
- You must consider mortgage loans or other debt on both the property you’ve sold, and on the replacement property. Even if you don’t receive cash back after the swap, but your liability goes down, that will also be treated as taxable income.
- It is important to know that in a 1031 exchange, the property to be bought must be of equal or greater value with the property sold.
- Any improvement or renovations must also be completed within the six-month timeframe.
- Personal property may also be treated as a 1031. This involves the swapping of a personal asset for another of a similar kind. Acceptable items include: vehicles, artwork, livestock, copyrights, etc.
- An individual may purchase another property before selling his own. This is considered the most complex of all possible 1031 exchanges, involving strict guidelines, and an expert is needed for this technique even more than for the others.
A word of advice: It is important to consult with a tax attorney before executing the 1031 tax benefit.