1031 Exchange Basics
Section 1031 of the Internal Revenue Code is one of the last great tax shelters available to investors today. When investment real estate is sold, the seller is responsible for paying capital gains taxes. In some cases, capital gains can be as high as 25 percent. By performing a 1031 exchange, investors can defer payment of these taxes.
As the name suggests, a 1031 exchange is the process of the property for sale being exchanged for a new piece of investment property. As long as this transaction is a “trade up” in value and debt, taxes are completely deferred.
By deferring taxes using a 1031, the wise investor is able to:
Increase cash flow
Purchase property in a more favorable area
Diversify or consolidate property
For instance, the exchange for vacant land, which is not yet producing income, for a commercial building that is bringing in rent would be considered a beneficial 1031 transaction.
What you need to know
Qualified Intermediary (QI)
Because exchange regulations are so complex, investors are required to use a QI to facilitate these transactions. The QI may not be any agent or fiduciary of the investor (i.e., attorney, realtor, CPA, etc.). Failing to comply with key requirements can invalidate the transaction, negate the tax benefits and result in unnecessary IRS penalties. The QI must be contacted to initiate the exchange before closing. The QI prepares the exchange agreement, escrows the proceeds, and coordinates the exchange with closing agents.
Certified Exchange Specialist® (CES®)
Investors considering exchanges are advised by the Federation of Exchange Accommodators (FEA) to consult with a CES®. It is essential for referring professionals (such as realtors, attorneys, title companies or accountants) to notify their clients that using a company that employs these specialists ensures transactions adhere to stringent IRS rules. These professionals are fully qualified to help you navigate the complexities of 1031 exchanges.
5 Facts to Know About 1031 Exchanges
Net selling price (NSP)
To avoid capital gains tax on the sale of your relinquished property, you must spend an amount equal or greater than your net selling price. (NSP = selling price less closing cost.)
What properties qualify
All real estate can be exchanged as long as it is held for investment or for productive use in a trade or business. House=Duplex=Land=Condo=Business Land=30-Year Lease=Deed for Deed
You must use a qualified intermediary (QI)
The regulations require that you use a QI to facilitate your exchange. Your QI does three main things: prepares the exchange agreement, escrows the proceeds after closing of the relinquished property, and coordinates the exchange with all closing agents.
You have 45 calendar days from closing on the sale of the relinquished property to identify up to three replacement properties. If you wish to identify more than three replacement properties, restrictions will apply.
You must close on one or more of your identified replacement properties within 180 calendar days of closing on your relinquished property.