A 1031 exchange is derived from Section 1031 of the IRS tax code. This section allows an investor who uses a properly structured 1031 exchange to sell a property, to reinvest the proceeds in a new property and to defer all capital gains taxes it would have had to pay on the sale. A 1031 exchange allows real estate investors to defer paying capital gains tax and instead build up their net worth through real estate investing. For example, let’s say you purchased a piece of property for $150,000 and then in a few years sell it for $550,000, which results in a net profit of $400,000. You normally would be subject to pay income tax at capital gains rates on the $400,000 gain on the sale of this property. Using a 1031 exchange, you would be able to reinvest the full $550,000 of sales proceeds by purchasing a new property and paying no capital gains tax on the sale.
To be able to qualify for a 1031 exchange, the new property purchased must be like-kind property of the property that was sold. According to the IRS, “Both properties must be similar enough to qualify as like-kind. Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. One exception for real estate is that property within the United States is not like-kind to property outside of the United States.”
There are other restrictions besides the like-kind property criteria. A 1031 exchange can only be performed between investment properties. You can’t do a 1031 exchange using personal property. You can also delay the exchange, which often occurs, because a third party acts as a qualified intermediary between you and the prospective buyer. According to the tax code, you have 45 days from the date you sell the property to identify up to three potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange, such as the seller of the replacement property or the qualified intermediary. The second deadline to meet for a 1031 exchange is that the replacement property must be acquired and the exchange completed no later than 180 days after the sale of the original property.
A 1031 exchange offers a great tax benefit but there are rules that must be followed. If you are selling real estate investment property, consult with GKG CPAs as to the options you have in executing a 1031 exchange.
Brian Reilly, Senior Accounting Manager