1031 Exchange for Real Estate Explained

Definition

A 1031 exchange for real estate or Internal Revenue Code Sections 1031, is a swap of one “like-kind” property for another in which there is no tax or limited tax due at the time of the exchange.
  • This means you can change the form of your investment without realizing the capital gain allowing your investment to grow tax deferred.
  • There is no limit on how many times or frequently you can do a 1031 exchange.
  • Once the cash is liquidated you will pay one tax at the long-term capital gain rate depending on your income.
  • “Like-kind” – is a broad, enigmatic, phrase that allows a lot of room to determine a “like-kind” property, it can be a multi-family, industrial, retail, strip mall, or sometimes a business for another business.

‘Delayed’ Exchange

  • A delayed exchange involves the swap of a property for another with a time in between to locate properties.
  • This is the case of most exchanges, they are also called three-party or Starker exchanges.
  • You need a Qualified Intermediary (middleman) who holds on to the fund after you “sell “ The initial property and then uses the money to purchase the replacement property.

Timelines

There are two deadlines that need to be met in a 1031 Exchange.

  • Identification Period – State you have 45 days to properly identify potential replacement properties after the sale of relinquished property.
  • Exchange Period – States that the replacement property must close within 180 days of the relinquished property sale OR the due date for the Exchangers tax return for the taxable year in wish the relinquished property was transferred, whichever is earlier.

Risks of 1031 Exchange

There are some scenarios in which the money will become taxable.

  • First, if you receive ash that is left over from the intermediary after and exchange, this money is known as a “boot” and will be taxed as partial sales proceeds from the sale of the original property.
    • This is typically taxed as a capital gain.
  • If you have not met the Identification and Exchange period, all of money included in the sale of the initial property will be taxed as sale proceeds and/or capital gains.
  • Debt on Property – if you exchange a property with debt for a property with less debt on it you will receive the difference as a gain, also know as “boot” and will be taxed as a capital gain.

Who Should Consider This?

  • Anyone thinking about selling a business use or investment property.
  • A 1031 offers the investor an opportunity to reinvest the federal capital gains that would normally be handed over to the IRS.
  • Anyone that is in this situation should heavily consider the possible reinvestment option, you can almost think of a 1031 as an interest free loan from the IRS to reinvest into your business.