1031 Tax-Deferred Exchange Details You Need To Know
The following information will provide you a basic overview of Internal Revenue Code Section 1031 Tax- Deferred Exchanges. Please consult with your professional tax, legal, and financial advisors regarding your specific financial position, real estate holdings, and how Internal Revenue Code Section 1031 pertains to you. It is important to understand that even though taxes on the sale of real estate can be deferred by implementing a properly executed 1031 tax-deferred exchange, in many cases it may financially more beneficial for a seller of real estate to simply pay the taxes due on the original sale.
What is a 1031 Tax-Deferred Exchange?
A standard 1031 tax-deferred exchange, also called a 1031 tax-deferred exchange, a “tax-deferred exchange, or simply a “1031”, is governed by Internal Revenue Code Section 1031. A 1031 potentially allows a seller of real estate to defer up to 100% of the gain, and therefore the income taxes, he/she has on the sale of property that is
held for investment.
Internal Revenue Code Section 1031(a)(1) states:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
The very basic description of a standard 1031 Exchange is that you can sell Property One (typically called the
relinquished property), and if you follow a myriad of IRS rules and restrictions you can buy Property Two (typically called the replacement property), and defer up to 100% of the income taxes on the sale of Property One. Asset Preservation Inc., API, a Qualified Intermediary providing 1031 tax-deferred account services on a national basis, defines a 1031 tax-deferred exchange as:
“Section 1031 of the Internal Revenue Code allows an owner of investment property to exchange property and defer paying Federal and State capital gain taxes if they purchase a like-kind property following the rules and regulations of the Internal Revenue Code. This allows investors to use all of their proceeds from their sale to leverage into more valuable real estate, increase cash flow, diversify into other properties, reduce management or consolidate into one property.”
What Does Like-Kind Property Mean?
The term “Like-Kind” pertains to the category, and not the specific type, of asset that qualifies for 1031 tax-deferred treatment. Gain on the sale of assets categorized for investment purposes that are used in a trade or business can be sold and the gain can be deferred if new assets are purchased to replace the assets that were sold, and all 1031 rules and regulations are met.
This can cause confusion, as some investors might think “Like-Kind” means if you sell a specific asset held for
investment such as a commercial office building, you must purchase a commercial office building to meet IRS 1031 tax-deferred exchange “Like-Kind” asset requirements. But this is not true. Any asset in the “Like-Kind” category will qualify as a suitable replacement property.
For example, a single family rental can be exchanged for raw land, or apartments or a commercial building.
In addition, properties can be exchanged anywhere within the United States. In addition, “Like-Kind” property can include Tenant-In- Common (TIC) and Delaware Statutory Trust (DST) real estate investments.
Do I have to Actually “Exchange” Real Estate Simultaneously?
No, a 1031 tax-deferred exchange can be completed as a simultaneous exchange meaning one asset is sold and a
new asset is purchased in the same transaction, a delayed exchange meaning Property One is sold first and Property Two is purchased later, or a reverse exchange meaning that Property Two is purchased first and Property One is sold later.
API comments that the majority of current 1031 tax-deferred exchanges are completed using the delayed format.
You have to decide to implement a 1031 exchange before Property One is sold. This means that you must establish your 1031 account with a Qualified Intermediary before you close escrow on the property you are selling. You cannot close escrow on your property today and then decide tomorrow to implement a 1031 tax-deferred exchange.
Adhering to the time requirements of Internal Revenue Code Section 1031 is extremely important. Important 1031 tax-deferred exchange dates are all calculated from the date Property One closes escrow:
- From the date Property One closes escrow, you have a maximum of 45 CALENDAR DAYS to name the next property, Property Two, you plan to buy.
- From the date Property One closes escrow, you have a maximum of 180 CALENDAR DAYS to close escrow on Property Two that you named in the initial 45-day period.
- In some cases, sellers may not receive the full benefit of the entire 180 days if the due date for their tax return in the year following the sale occurs prior to the end of the 180 day period. In that case, the taxpayer would need to file an extension in order to have the benefit of the full 180 days.
What About the Equity From The Sale Of Property One?
To receive a full deferral of income taxes, property Two must receive 100% of the net equity proceeds that came out of Property One. The sales proceeds for Property One must go from the title/escrow company directly to your Qualified Intermediary. You must not receive any funds from the buyer of your property or from the title/escrow company. Funds you receive are “boot”, and are generally subject to income taxes.
It is important to understand that receiving funds from the sale of Property One does not invalidate your 1031 tax-deferred exchange, but it will potentially subject the amount you receive to income taxation.
To Defer All Taxes, Can Property Two Cost Less Than
Property Two must cost at least as much as much as what Property One sold for. To benefit from 100% income tax deferral, you cannot “trade down” from Property One into Property Two. The IRS allows full tax deferral only if you buy a replacement property of equal or greater value. “Trading Down” to a lower priced Property Two does
not invalidate your 1031 tax-deferred exchange, but it will potentially subject you to income taxation on the decreased cost of Property Two as compared to Property One.
Property Two must have at least as much debt as Property One unless you pay down the new debt with extra cash. Having less debt on Property Two does not invalidate your 1031 tax-deferred exchange, but it will potentially subject you to income taxation on the decrease of debt on Property Two as compared to Property One.
Is a 1031 Tax-Deferred Or Tax-Free?
A 1031 tax-deferred exchange is tax-deferred, it is NOT tax-free. It is important to understand that although
income taxes can be deferred currently on the sale of Property One, when Property Two is sold in the future
there could be income taxes to pay at that time. It is also important to understand that when Property Two
is sold at some time in the future, income taxes on the gain from the sale of Property Two could be higher, and
reduce or eliminate the income tax benefits from the sale of Property One.
It is very important to understand that there are many costs related to selling Property One, buying Property
Two, and in executing a properly structured 1031 tax-deferred exchange. These costs must be carefully
reviewed and studied because these costs could easily surpass any income tax benefits a seller of real
estate could receive in a 1031 tax-deferred exchange transaction.