A 1031 exchange (which refers to a section in the IRS tax code), is a way for real estate investors to defer paying tax on the sale of an investment property. It is a strategy and method for selling one property, that’s qualified, and then proceeding with an acquisition of another (also qualified) property within a specific time frame. While it’s not usually a physical exchange of one property for another, it allows the taxpayer to qualify for a deferred gain treatment by the IRS.
A real estate investor should consider an exchange when he/she expects to acquire a replacement “like kind” property subsequent to the sale of his or her existing investment property. Otherwise, selling an investment property may trigger the payment of a capital gain tax. This process is usually facilitated by a Qualified Intermediary through which the proceeds from the sale of one property must go through (not into your hands or the hands of one of your agents!), or the proceeds will become taxable. The entire cash or monetary proceeds from the original sale have to be reinvested towards acquiring the new real estate property. Any cash proceeds retained from the sale are taxable.
There are crucial dates during which the party selling a property must identify other replacement properties that are proposed or that he/she wishes to buy. It’s not uncommon to select more than one property. This period is scheduled as exactly 45 days from the day of selling the relinquished property. This 45 day timeline must be followed under any and all circumstances and is not extendable, even is the 45th day falls on a weekend or holiday.
The exchange period is the period within which a person who has sold the relinquished property must receive the replacement property. This period ends at exactly 180 days after the date on which the person transfers the property relinquished, or the due date for the person’s tax return for that taxable year in which the transfer of the relinquished property has occurred, whichever situation is earlier.
The total purchase price of the replacement “like kind” property must be equal to or greater than the total net sales price of the relinquished real property. All of the equity received from the sale of the relinquished property must be used to acquire the replacement (like kind) property. To the extent that either of these rules are violated, will determine the tax liability accrued to the person executing the exchange. If the replacement property purchase price is less, there will be a tax liability.
If you’re thinking of buying or selling real estate as an investment, be sure you understand 1031 exchanges and seek help from a real estate agent and Qualified Intermediary.