If you’re an investor who is looking to sell property, IRC Sec 1031 has good news for you: you can defer any and all capital gains by reinvesting the proceeds of your sale into new property. As IRC 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….1031 exchanges allow investors to defer capital gain taxes as well as facilitate significant portfolio growth and increased return on investment.
Of course, to take full advantage of the benefits available, it’s critical that you have a thorough understanding of Section 1031 code and the mechanics involved in the exchange.
The IRS breaks it down as follows:
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Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange.
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Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.
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The exchange can include like-kind property exclusively or it can include like-kind property along with cash, liabilities and property that are not like-kind.
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If you receive cash, relief from debt, or property that is not like-kind, however, you may trigger some taxable gain in the year of the exchange.
To accomplish a Section 1031 exchange, as the IRS also notes, there must be an exchange of properties, and there are different types of exchanges:
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The simplest type of Section 1031 exchange is a simultaneous swap of one property for another.
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Deferred exchanges are more complex but allow flexibility. They allow you to dispose of property and subsequently acquire one or more other like-kind replacement properties.
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A reverse exchange is somewhat more complex than a deferred exchange. It involves the acquisition of replacement property through an exchange accommodation titleholder, with whom it is parked for no more than 180 days. During this parking period the taxpayer disposes of its relinquished property to close the exchange.
To qualify for Section 1031, the IRS also has a wide array of requirements:
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Both the relinquished property you sell and the replacement property you buy must meet certain requirements.
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Both properties must be held for use in a trade or business or for investment.
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Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.
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Both properties must be similar enough to qualify as "like-kind." Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate.
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While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable. The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier.
The IRS page on the guidelines offers more details. The foregoing high-level summary concerning the application of IRC Sec. 1031 should get the message across to not try to do this yourself without help from your attorney or other advisor. To say that the rules are complex is an understatement of biblical proportions!