There are plenty of opportunities in which to invest your money, including stocks, bonds, precious metals and many more, but the one that seems most tangible for some investors is real estate.
People have varying experience with real estate. For instance, some have an understanding through purchasing their own house, where some have been investing in investment-grade real estate for years. With real estate, you can see it, touch it, change it, and possibly even use it every day. In addition, real estate can be a potentially good source of cash flow and/or appreciation.
All that being said, if you decide to one day sell the real estate you invested in, chances are you could be taxed a significant amount. This is where the Internal Revenue Code Section 1031 comes in to play.
What is Involved in the 1031 Exchange Process?
A 1031 exchange (also called a like-kind exchange) is named after a provision in the tax code. It states that if you use the proceeds from the sale of a real estate investment property to buy investment property of like kind, you can defer the capital gains tax.
At a very basic level, the 1031 rules are:
- Sell a real estate investment property.
- Put the proceeds in the hands of a third party known as a Qualified Intermediary.
- Within 45 days, identify the new property (or properties) to buy.
- Close on the new property within 180 days using revenue from the sale of the old property.
By following these 1031 rules, you buy and sell real estate without handling any cash. Technically, you’re trading properties with someone because the money bypasses you and goes straight from closing to the qualified intermediary. And in case you’re wondering… no, this is not tax evasion. Participating in a 1031 exchange is completely legal and accepted by the IRS, as long as you follow the rules.
Requirements of a 1031 Exchange:
1. The old property and the new property must be “like-kind.”
According to the IRS’s definition of this term, “properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality.” Like-kind relates to how the properties will be used. The old property, as well as the new property must be held for investment or utilized in a trade or business. It is important to note that investors and developers who strictly “flip” or re-sell properties do not qualify for exchange treatment because their intent is resale rather than investment.
2. New property must be identified within 45 days of closing on the old property.
Starting the day after closing, you will have 45 calendar days to identify a new property. No extensions are allowed under any circumstances, including holidays. As many as three potential new properties can be identified without regard to cost. No formal filing is required to be made with the IRS; however, it is the responsibility of the qualified intermediary to accept the list on behalf of the IRS and document the date it was received.
3. One or more of the new properties must be purchased and closed on 180 days after closing on the old property.
A new property from the list provided to the Qualified Intermediary must be purchased, and the title is required to pass by the 180th day. There are no extensions.
4. 1031 Exchange Process Requires Use of a Qualified Intermediary.
A Qualified Intermediary is essential to the completion of a successful 1031 exchange. Technically, this third party sells your property on your behalf, buys the new replacement property, and then transfers the deed to you. It is the responsibility of the Qualified Intermediary to hold the proceeds, prepare the legal documents, and attempt to ensure that the transaction is completed within the IRS guidelines.
1. Person(s) named as owners on the old property must be the exact same as the person(s) named on the new property.
A basic rule of 1031 exchanges is that the taxpayer who owns the old property must be the one that does the exchange and whose name is on the title of the replacement property. Pay close attention to titles that have names of married persons or corporations, LLCs, and other entities as all names must be a mirror image.
2. The new property must be of equal or greater value.
The new property has to be of equal or greater value of the one that is sold, and all of the cash profits must be reinvested. This is the only way to defer 100% of the tax on the gain of the sale.
3. New and old property titles cannot be in the same name at the same time.
A taxpayer may not have both the old as well as the new property titles in their name at the same time. If you find an investment opportunity that you must act on before you have sold your current property, someone other than the taxpayer will hold legal title in what is commonly referred to as a qualified parking arrangement. Once the old property is sold, the proceeds will be directed to the temporary titleholder. Then the property may be transferred from the parking arrangement directly to the taxpayer.
For more information on IRC Section 1031 click here.