1031 “Like-Kind” Exchange of Real Estate
Ordinarily, when you sell real estate, you have to pay capital gains taxes on your profit. However, the Internal Revenue Code (IRC) offers a couple of exceptions to this. IRC Section 1031 is one such exception. It allows you to defer the payment of taxes if you reinvest the proceeds from the sale in the same kind of property according to the rules of the section. This is known as a “like-kind” exchange. (Section 1031 allows for the exchange of other types of property as well, but it is often used specifically for real estate transactions.)
Although you are still ultimately liable for the capital gains tax (when you sell the replacement property), the ability to defer capital gains tax can be an important advantage. This is especially true if your business is relatively young or you are just starting out investing in real estate. 1031 exchanges are available for taxpaying entities, including individuals, business entities, and trusts.
How does it work?
While the ideal 1031 exchange would be a quick simultaneous swap of both properties, the typical exchange is a little more complex. It's known as a “deferred exchange” (also known as a Starker exchange, after the case in which the rules were outlined).
To execute this exchange properly, a “qualified intermediary” is used to facilitate the exchange. The intermediary holds the sale proceeds from the first property until the replacement property is purchased. The qualified intermediary then uses these funds to pay for the replacement property and deliver it to the taxpayer/seller.
In order to defer all potential capital gains taxes on the sale, all proceeds must be invested in the replacement property, which should be of equal or greater value. If the exchange is a “trade down,” the leftover cash from the sale of the first property is known as the “boot.” (Boot received is cash or any other property transferred to the taxpayer as part of the exchange. The boot is considered taxable.)
For instance, if you sell the first property for $500,000, and pay $400,000 for the replacement property, the $100,000 you get back is the boot. The same is true of the mortgage. If the properties are of the same value, but the second property has a lower mortgage, this can result in boot.
1031 exchange rules
While the 1031 exchange can be a valuable tool in business or real estate investment, it is subject to many rules, including the following:
- Time limits: Once the first property is sold, you have 45 days to identify a replacement property. The replacement property must be acquired within 180 days of the closing (or of the income tax return due date for the year the first property is sold, whichever comes first).
- Types of property: Only business or investment property can be exchange, not personal property.
- “Like-kind”: Only similar properties can be exchanged. However, for real estate, the rules for this are very flexible. One restriction is that it does not apply if one property is in the U.S. and one is not.
Additionally, for the year of the exchange, the taxpayer must file Form 8824 with the IRS to report the like-kind exchange.
If you're a business owner or a real estate investor, a 1031 exchange is a valuable tool that can help you grow your business or increase your investment assets. However, it's important that it be done correctly, according to the rules of the IRC, in order to avoid inadvertently nullifying the exchange and being subject to taxation.
Contact Helix Law Firm for help with a 1031 exchange
Our real estate attorney, Tom Parashos, is also a licensed California Real Estate Broker and owner of a successful real estate business. We can not only handle all aspects of the 1031 exchange process, but we can also help you locate a suitable replacement property if you have not found one on your own.