To minimize or defer the tax bill when selling investment real estate, investors commonly use what’s known as a 1031 or Like Kind Exchange. In this article you’ll learn what a 1031 exchange is, how a 1031 exchange works, what the 1031 exchange rules are, the 1031 exchange timeline, and then we’ll cover some frequently asked questions.
What is a 1031 Exchange?
“1031 Exchange” is a colloquial reference to Section 1031 of the United States Internal Revenue Code (26 U.S.C §1031), which defines the conditions for tax deferral on the sale of real estate. Specifically, the tax code states that:
“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.”
In other words, taxes can be deferred on the profitable sale of a commercial property as long as the proceeds are “exchanged” into a new property of “like kind” that is held for investment purposes. Deferral can provide a powerful tax benefit that acts as an incentive for continued real estate investment, but in order to take advantage of it, the correct type of exchange must be chosen and the transaction must be executed flawlessly.
How Does a 1031 Exchange Work?
There are 4 types of commonly used 1031 Exchanges. However, only one of them is dominant while the others are saved for specific circumstances unique to a commercial real estate investor’s needs. They all benefit from the same tax deferral incentive, but the rules vary slightly for each so it’s always best to consult a qualified attorney or CPA before choosing and/or entering into one of them. The types are:
- Delayed Exchange: The “Delayed Exchange” is the most common type and occurs when an investor sells their property (the “relinquished” property) and uses the proceeds to acquire a new property (the “replacement” property). Under the Delayed exchange rules, the replacement property must be identified within 45 days of sale and closed within 180 days to take full advantage of the tax deferral incentive.
- Simultaneous Exchange: It’s just what it sounds like. In a Simultaneous Exchange, the sale of the relinquished property and the purchase of the replacement property are closed at the same time. Executing a Simultaneous Exchange requires a high degree of precision because delays could result in the nullification of the exchange and the application of full taxes to the sale.
- Reverse Exchange: Again, a Reverse Exchange is just what it sounds like. In a Reverse Exchange, the replacement property is acquired first and the relinquished property is sold second. While the terms of the transaction are relatively simple, the execution isn’t. A Reverse Exchange requires that the replacement property be purchased in cash and that the relinquished property be identified within 45 days and sold within 180 days.
- Construction Exchange: In a Construction Exchange, an investor sells the relinquished property, identifies a replacement property, and places it into the hands of a third-party known as a Qualified Intermediary (QI). While in the QI’s hands, the owner can use the sales proceeds for renovations on the replacement property. Upon completion, the investor takes possession of the replacement property under two conditions: (1) It must be “substantially the same” as it was before the renovations; and (2) construction must be completed within 180 days of the relinquished property’s sale date.
Regardless of the type used, completing a 1031 Exchange can be complicated because there are a series of specific requirements that must be met to be eligible for full tax deferral.
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