If you are a real estate investor and frequently buy and sell real estate, you must know about §1031 exchanges.
A transaction structured as a §1031 exchange can defer taxable gains on certain real estate sales. Sometimes referred to as like-kind exchanges, a §1031 exchange allows a person to sell one property and invest the proceeds from the sale of that property into the purchase of another property, without paying any capital gains taxes on the sale of the first property. In other words, the capital gains taxes normally due on the sale of the first property are deferred until the sale of the second property. Things really get interesting when the sale of the second property is also used for a §1031 exchange into the purchase of a third property, and then a fourth property, and so on, deferring capital gains tax for years. Generally speaking, any real property can be exchanged, provided it is held for “productive use in a trade or business” or for “investment” and is exchanged for property of “like kind” that will also be held for one of these same purposes.
To take advantage of a §1031 exchange, the transaction must be structured as an exchange, rather than normal sale and purchase. An entity known as a “qualified intermediary” must be involved with the sale of the first property and the purchase of the second, replacement property. The seller of the first property normally signs an exchange agreement and assigns the purchase contract on the first property to the qualified intermediary. At closing, the proceeds from the sale are not sent to the seller but to the qualified intermediary, who holds the proceeds until the replacement property is identified. Once the replacement property is identified, the closing is set and the qualified intermediary releases the proceeds to be used for the purchase of the replacement property. So long as all the steps are followed, no capital gains tax is due on the proceeds from the sale of the first property.
There are some restrictions involved in §1031 exchanges. Already mentioned are the requirements that the properties involved must generally be used in business or held for investment. Exchanges are not used for private residences or vacation homes. The second property must also be “like-kind” to the property relinquished. The rules are quite broad on what is considered to be like-kind, but you will want to work closely with your real estate attorney to make sure the exchange property will qualify. Further, there is the “same taxpayer rule,” which holds the same taxpayer must relinquish the first property and purchase the replacement property. Finally, to defer all capital gains taxes, the replacement property must be equal or greater in value, equity, and debt than the relinquished property. There are also exceptions to these rules. Again, it is important to work with an experienced attorney to make sure you are following the law and that your transaction will qualify as a like-kind exchange under §1031 of the Internal Revenue Code.
To take advantage of this opportunity there are timelines to follow. From the sale of the original property, you have 45 days to locate and identify the next purchase. Running coterminous with the 45-day timeline, investors have 180 days from the closing on the first property to close on the next property.
A §1031 exchange, and the tax deferment it offers, is an incredibly powerful tool for property investors. It is, however, something that requires experienced real estate and tax professionals to navigate properly.
The real estate attorneys at Skeeters, Bennett, Wilson & Humphrey can handle your §1031 exchange, making sure the transaction is structured properly from the signing of your purchase contract through closing of the first property and the replacement property. If you would like to discuss a §1031 exchange, schedule an appointment with one of our real estate attorneys.