1031 Exchanges Defer Taxes
The 1031 Exchange has been cited as the most powerful wealth building tool still available to taxpayers. It has been a major part of the success strategy of countless financial wizards and real estate gurus. Taking its name from Section 1031 of the Internal Revenue Code, a tax-deferred exchange allows a taxpayer to sell income, investment or business property and replace it with a like-kind property.
Capital gains on the sale of this property are deferred or postponed as long as the IRS rules are meticulously followed. This is a wise tax and investment strategy as well as an estate planning tool. In theory, an investor could continue deferring capital gains on investment property until death, potentially avoiding them all together.
1984 Legislation Changed Some Aspects of 1031 Exchanges
In the early days of “like-kind exchanges,” the term was taken quite literally and often posed difficulties. For instance, if you owned a three-story brick apartment building that you wanted to sell through a 1031 exchange, you would have to find another three-story brick apartment building whose owner wanted to swap. Then the two of you would meet and the exchange would take place.
In the past, there were no time constraints on the exchange. The IRS demanded stricter controls on the process, which resulted in Congress passing in 1984 Section 1031(a). This legislation limited deferred exchanges, further defined “like-kind” property and established a time table for completing the exchange.
Qualifying for a 1031 Exchange
Real estate property held for business use or investment qualifies for a 1031 Exchange. A personal residence does not qualify and, generally, a fix-and-flip property also doesn’t qualify because it fits in the category of property being held for sale. Vacation or second homes, which are not held as rentals do not qualify for 1031 treatment; however, there is a usage test under Paragraph 280 of the tax code that may apply to those properties. A tax expert should be consulted in this case.
Land, which is under development, and property purchased for resale do not qualify for tax-deferred treatment. Stocks, bonds, notes, inventory property, and a beneficial interest in a partnership are not considered “like-kind” property for exchange purposes.
To qualify as a 1031 exchange today, the transaction must take the form of an “exchange” rather than just a sale of one property with the subsequent purchase of another. First, the property being sold and the new replacement property must both be held for investment purposes or for productive use in a trade or a business. They must be “like-kind” properties.
The following types of real estate swaps fit the requirement for a qualified exchange of “like-kind” property:
Today, you could exchange that brick apartment building for raw land, a warehouse, or a small office building. However, there are strict time constraints which must be met or the 1031 Exchange will not be allowed and tax consequences will be imposed.
Prior to 1984, virtually all exchanges were done simultaneously with the closing and transfer of the sold property,(Relinquished Property), and the purchase of the new real estate, (Replacement Property). In addition to the problems encountered when trying to finding a suitable property, there were difficulties with the simultaneous transfer of titles as well as funds.