1031 Tax Exchange

As the infamous Margaret Mitchell put it, there is never a convenient time for taxes, especially for investors who are looking to reinvest their proceeds from their sale of real property. However, with proper planning and guidance from your accountant and real estate attorney you may be able to preserve more of your assets. 

If you have been thinking of selling property, you may have heard of a “1031 Tax Exchange”. The term derives from Internal Revenue Code Section 1031, which states “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment”.

To simplify this; once you sell property the buyer’s attorney will ask you what you gain is. Now if you bought your property for $400,000 and have sold it for $450,000 your gain will roughly be $50,000, less expenses that your accountant could go into further detail with you about. I always advise clients to speak with a tax professional prior to reporting their gain in any transaction. You are subsequently taxed on this gain. This typically occurs when you go to file your taxes and your accountant so sweetly asks “Have you sold any property this year”. 

However, in a 1031 Exchange, a Qualified Intermediary holds the proceeds for you to reinvest in a “like – kind” property therefore allowing investors to defer capital gain taxes as well as facilitating a return on their investment. To accomplish a successful 1031 Exchange you should first review the entire transaction with you real estate attorney and tax advisor. Then you will need to find a Qualified Intermediary. Your attorney, real estate agent, and tax advisor should have a list of good recommendations. You then enter an “assignable” contract to sell the property, and the qualified intermediary will prepare all the exchange documents for your attorney. A replacement property that you plan to purchase with the proceeds must be identified within 45 days of sale to defer capital gains taxes. 

The property you plan to acquire must be like-kind, according to the IRS which is actually a broad scope. This means the property is like in nature or character. The IRS regulations state that “all real property is like-kind to all real property”. This could be a single-family rental for a mulit-family rental or industrial property for rental vacation property. The like-kind requirement does not mean selling and buying the exact same type of property.  However, this excludes a taxpayer’s primary residence as Section 121 provides tax exclusion for a taxpayer’s primary residence held for two (2) of the past (5) years. 

If all of the funds held by the Qualified Intermediary are used to purchase the replacement property, and all of the IRS requirements are met, the exchange is complete, and you have successfully deferred capital gains on your sale.