The simplistic explanation of a 1031 real estate exchange is that you negotiate the sale of your property and transfer ownership to a “Qualified Intermediary”, a professional position just for these exchanges. Your Intermediary then sells the property and holds the proceeds on your behalf. You then identify new properties and negotiate a purchase. The Intermediary makes the purchase with the proceeds they held for you and transfer the ownership of the new property to you.
With the 1031 real estate exchange, the capital gains and recapture taxes you would have otherwise owed from the sale of the first property are deferred until you sell the new property. This can also be done in reverse by acquiring the new property before selling the old property, however the process is more complex.
Remember these nine extra rules while undergoing 1031 real estate exchange:
- Any property involving in a 1031 real estate exchange must be used for business or investment. You can’t sell or receive a home, land under development or property purchased for resale. Sometimes the secondary and vacation homes can be qualified as investments but only if personal use was quite limited.
- Property received must be of “like-kind” to the property sold. In case of real estate, nearly everything is of like-kind; undeveloped land is of like kind to corporate offices and apartment buildings.
- The Intermediary is a necessary legal buffer because if you receive any money before the exchange is finished completely, then the tax-deferred treatment of gain is broken and all taxes become due immediately.
- Due to the complexity of 1031 exchanges, you are not allowed to act as your own Intermediary, nor designate anybody else who has acted as your agent for the last two years including the real estate agents, accountants, investment brokers, employees, and attorneys, so there are a brand of professionals who are Qualified Intermediaries.
- From the day the property is sold, you have 45 calendar days to find the potential new properties and 180 days to complete the exchange. These windows are strict, and they count holidays and weekends which cannot be extended or run concurrently.
- Identification must be made in writing with a clear description of the new properties and must be delivered to and signed by the Intermediary or current owner of the new property.
- Purchasing a new property of equal or greater value than the one you sold is a good idea because any funds left over at the end or additional property received with the new real estate are counted as “boot” and immediately taxed as capital gains. When the newly acquired property is transferred back to you by the Intermediary along with any boot such as leftover funds or the additional property acquired then the exchange is completed. Fortunately, the boot and net gain due to the real estate exchange are taxed instantly in reality and they do not void the deferral of capital gain and recapture taxes that were rolled into the new property.
- The cost basis for the new property is equal to the basis of the old property. The new basis is decreased by the amount of any boot received and then increased by any gain which is taxed during the exchange.
- Last but not least; be cautious while engaging in this kind transaction with family members because the tax-deferred gains can be forced into recognition in an exchange between related parties if either party sells their property before two years pass.
The most beneficial use of the 1031 exchange rules is to keep exchanging the acquired property. The deferred taxes will roll into that property to be recognized on its sale. If the property is retained long enough, and the last acquired property is passed on to heirs, it will receive a step up in the cost basis at which point the taxes due vanish effectively. A 1031 exchange is tricky to manage but definitely worth investigating.
If you have questions about the 1031 real estate exchange, contact me today at 615-326-TAX9 for a free consultation.
Stephen Wallick started Stephen Wallick & Associates to provide tax and accounting services to Contractors, Real Estate Investors, and Realtors. Steve specializes in IRS Tax Resolution services and works with his clients to resolve cases under scrutiny by the IRS. As a tax professional and enrolled agent, Steve can save you money with IRS loopholes each year. With over 20 years going up against “The Man”, Steve is uniquely qualified to resolve even the toughest IRS cases.