During the real estate downturn, few investors were turning profits on the sale of property and Internal Revenue Code (IRC) Section 1031 Exchanges were not very common. I’m here to tell you they are back big time. There is a lot of confusion and misinformation about the 1031 Exchange. The purpose of this blog is to review some of the major points.
What is an IRS Section 1031 Exchange?
The “1031 Exchange” allows investors to defer taxes on capital gains from investment properties. In today’s hot real estate market, investors are using this loophole to defer paying taxes on their real estate profits. This powerful tool allows the reinvestment of the gross profits, versus net profits after taxes.
What are the rules of the 1031 Exchange?
There are important IRS rules that must be followed to take advantage of the 1031 Exchange. If any of these rules are not followed, then the 1031 Exchange will not be allowed by the IRS.
To accomplish a Section 1031 Exchange, there must be an exchange of properties. The simplest type of Section 1031 Exchange is a simultaneous swap of one property for another. Deferred exchanges allow you to sell one property and subsequently acquire one or more other like-kind replacement properties. There are strict time limits to complete a Section 1031 Exchange. The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties.
The second limit is that you must close on the replacement property no later than 180 days after the sale of the exchanged property. I am over-simplifying the process. It can be very tricky and you should involve a third party Section 1031 Exchange company and a REALTOR familiar with 1031 Exchanges to guide you through the process.
2. Access to Funds
To qualify for a Section 1031 exchange, the sale of one property and acquisition of another property must be part of an integrated transaction using “exchange facilitators”. The exchange facilitators are neutral third parties who handle all of the funds during the transaction pursuant to rules provided by the IRS. You, as the client, can NOT have access to the funds at any time. If the proceeds from the sale enter your bank account, you have disqualified yourself from taking advantage of the tax deferred exchange.
3. Qualifying Properties
To qualify for a 1031 exchange, both properties must be investment properties. Examples include rental properties that the owner has never occupied or vacant land. Your primary residence or second home will not qualify for a Section 1031 Exchange.
Planning Ahead for Your Exchange 1031
The 1031 Exchange is a great way to maximize real estate profits by reinvesting the gross (instead of net of tax) proceeds of an investment property. However, the exchange must be planned in advance, with a third party exchanger set up, to take advantage of this tax loophole.
Consult a tax professional or refer to the IRS Website for critical details about a 1031 exchange.
*With tax reform in the news lately, you should know that as of the date this blog goes to publication, both the House and Senate bills have maintained the Section 1031 Exchange in its present form.