Section 1031 of the IRC (Internal Revenue Code), also known as the Internal Revenue Title, is a comprehensive set of laws created by the Internal Revenue Service (IRS) and enacted by Congress as Title 26 of the United States Code. The IRC is organized by topic and covers all relevant rules related to income, gift, estate, sales, payroll, and excise taxes.
One significant benefit of the Internal Revenue Code is that it allows owners of business or investment real estate to sell their relinquished property and acquire new replacement property without paying taxes on the profit of the sale of the old property. These “tax-deferred exchanges” allow property owners to continue investing in the original property by using the exchange value in one property to buy another rather than receiving cash for the exchange value.
As long as the property owner (also referred to as the “taxpayer” or “exchanger”) follows the many rules governing exchanges, the IRS will not recognize the sale as a taxable event. This principle is based on the idea that the taxpayer is merely continuing their investment in the original property, and thus, the transaction should not be subject to capital gains taxes.
This article aims to offer a comprehensive overview of the fundamental rules and concepts governing 1031 exchanges while clarifying some prevalent misconceptions. Below, each concept is discussed in detail.
Using a 1031 Exchange, Taxes are Deferred, Not Eliminated
Suppose Betty intends to invest the $40,700 she would have otherwise paid in taxes into new real estate, she can opt to defer her capital gain, depreciation recapture, and other tax liability instead of eliminating them. However, when she eventually decides to cash out by selling the property she bought as a replacement property, she will be liable for the $40,700, plus any additional tax liability accrued on the new property.
One notable exception is when an exchanger passes away, their heirs receive a “step-up” in basis that effectively eliminates any deferred taxes.
Role of a Qualified Intermediary
The most prevalent form of 1031 exchange is a “forward” or “delayed” exchange, which uses a Qualified Intermediary (QI). This process does not require an actual swap of properties between the exchanger and the other party. Instead, it allows the exchanger to sell their relinquished property to a third-party buyer and subsequently purchase replacement property from a third-party seller within 180 days, hence the “delayed” terminology.
The essential components of this structure are that: (1) the QI assumes the exchanger’s rights in both the relinquished and replacement property contracts, enabling the taxpayer to “exchange” properties with the QI as required by Section 1031, and (2) the QI obtains the net proceeds from the sale of the relinquished property and utilizes them under the taxpayer’s guidance to purchase the replacement property. If the taxpayer or a disqualified individual, such as a relative or agent, receives the funds, even briefly, the exchange will be invalid.
1031 Exchange Timing Requirements
Section 1031 imposes stringent timing and identification criteria. Let’s take an example. If Betty chooses to participate in an exchange, she must identify replacement property within 45 days of concluding the sale of her apartment building, and she has a total of 180 days from the closing date to purchase the replacement property (135 days from the identification deadline).
Regarding identification, Betty has the option to identify up to three potential replacement properties and ultimately purchase any one of them. If she wants to identify more than three properties, she may do so as long as the total fair market value of all identified properties does not exceed 200% of the value of the relinquished property. In Betty’s scenario, the combined value of four or more identified properties could not surpass $500,000. If a taxpayer breaches this “200% rule” by identifying more than three replacement properties, he or she must close on 95% of the value of all replacement properties, which generally entails purchasing all of them.
A 1031 exchange is a tax-deferral tool that allows real estate investors to defer their capital gains taxes, depreciation recapture taxes, and other tax liabilities when they sell their investment property and reinvest the proceeds into a new property. By following the rules and regulations set by the IRS, investors can enjoy the benefits of tax-deferred exchanges and continue to grow their real estate portfolio. If you’re considering a 1031 exchange, it’s essential to work with a qualified intermediary and seek the advice of a tax professional to ensure you’re adhering to all the necessary rules and regulations. With careful planning and execution, a 1031 exchange can greatly maximize your investment returns and grow your real estate portfolio while deferring taxes.
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