A 1031 exchange, also called a like-kind exchange, is a transaction under United States law which specifies that if an asset such as land or a building is sold and the proceeds of the sale are then reinvested in a like kind asset, then no gain or loss is recognized. This allows the deferment of capital gains taxes.
A 1031 exchange is similar to a traditional IRA or 401K retirement plan. When someone sells assets in tax-deferred retirement plans, the capital gains that would otherwise be taxable are deferred until they begin to cash out of the retirement plan. The same principle holds true for tax-deferred exchanges or real estate investments. As long as the money continues to be re-invested in other real estate, the capital gains taxes can be deferred. Unlike traditional retirement accounts, rental income on real estate investments will continue to be taxed as net income is realized.
This law is defined by section 1031 of the Internal Revenue Code. Investors must contact a qualified intermediary (QI) to facilitate the exchange. See below for the rules that apply to 1031 Exchanges. You can also visit TitleOne, a Qualified Intermediary, for more great information.
In order to qualify for this exchange, certain rules must be followed:
- Both the relinquished property and the replacement property must be held either for investment or for productive use in a trade or business. A personal residence cannot be exchanged.
- The asset must be of like-kind. Real property must be exchanged for real property. Personal property must be exchanged for personal property.
- The proceeds of the sale must be invested in a like kind asset within 180 days of the sale. However, the property must be identified within 45 days.
Frequently, the most difficult component of a 1031 exchange is identifying a replacement property within the first 45 days following the sale of the relinquished property. The IRS is strict in not allowing extensions.
1031 Exchange Example
An investor buys a Retail Center (a commercial property) for $1,000,000. After six years he sells the property for $1,200,000. This results in a gain of $200,000 on which the investor would have to pay a capital gains tax. However, if he invests the $1,200,000 in another property (like-kind commercial, not necessarily a Retail Center), then he does not have to pay any taxes on it now.
Here are the steps he would follow for this exchange.
- The investor decides to sell his investment property and do a 1031 exchange.
- He contacts a qualified intermediary (QI). A QI is a corporation that facilitates 1031 Exchanges, similar to an escrow company.
- The investment property is put on the market.
- An offer to purchase the investment property is accepted.
- Escrow for the sale is opened, and a preliminary title report is produced.
- The QI sends required exchange documents to the escrow closer for signing at property closing.
- Escrow closes.
- Within the first 45 days after the close of escrow on the sale of the relinquished property, the investor identifies replacement property as required by law.
- Within 180 days after the close of escrow on the sale of the relinquished property, the investor closes on the replacement property that he identified. This completes the exchange.