1031 Exchange: What Investors Need to Know
Are you preparing to sell your real estate assets and thinking about doing a 1031 exchange? Are you even sure what a 1031 exchange is? The process can get complicated, but here are the general steps and rules that investors should understand before selling their CRE.
What is a 1031 Exchange?
A 1031 exchange, also called a like-kind exchange or a Starker, is a transaction that essentially swaps one investment or business-use asset for another without tax consequence. It permits a seller to reinvest their sales proceeds into a similar property, thereby deferring the capital gains taxes that would otherwise be due.
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.”
By law the seller must use an independent third party to handle the exchange between the sale of the relinquished property and purchase of a replacement property, as the money cannot be touched. At closing, all proceeds of the sale will be forwarded to a defined Qualified Intermediary. Make sure to include 1031 exchange language in the sales agreement.
Identify a like-kind replacement property
After selling the relinquished property the exchange clock begins ticking. The seller now has 45 calendar days to identify a like-kind replacement property to purchase and alert the Qualified Intermediary in writing. Keep in mind that the IRS includes weekends and holidays in their timeframe, and they are very strict with this rule.
Purchase the replacement property
Once a replacement property, or properties, has been identified they must be acquired within 180 days. Again, make sure to include 1031 exchange language in the sales agreement. Once conditions are satisfied, the Qualified Intermediary will forward the funds for the closing.
File Proper Forms
When using a 1031 exchange, the taxpayer must file form 8824 with the IRS when filing their Federal Income tax return. The 1031 exchange should be reported for the year in which it began.
For Investment Only
A 1031 exchange can only be used for investment and business properties, not personal. Sorry your vacation home in the Alps doesn’t count.
The price of the replacement property must be equal to or greater than the relinquished property in order to defer 100% of the capital gains tax.
Don’t Let “Like-Kind” Worry You
In a 1031 exchange the replacement property must be “like-kind” but in actuality that statement is very broad in scope. It simply means that the taxpayer is exchanging real property for real property. So, land can be exchanged for a medical office building, or retail for industrial, just as long as both assets are located within the United States.
If there is cash left over after the purchase of the replacement property, referred to as “boot”, it is taxed as partial sales proceeds, generally as a capital gain. The Qualified Intermediary pays it to the taxpayer at the end of the 180 days.
Legislation Facing 1031 Exchanges
The current 1031 exchange tax law could be on Congress’s chopping block. Highly used and supported among real estate investors, the exchange provides the flexibility needed to manage portfolios and if repealed could seriously threaten real estate values. Visit http://www.save1031.com for more information on the current tax reform debate.
When planning on buying or selling commercial real estate assets, using a 1031 exchange or not, it’s always best to use a professional. If you have any questions, or just need to be pointed in the right direction, contact the team at SVN/Graham, Langlois & Legendre today.
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