With the housing market booming and the economy picking up speed, we are seeing a resurgence in 1031 exchanges.
A 1031 exchange allows you (the “exchangor”) to defer paying taxes on investment property when it is sold, so long as those proceeds are reinvested into other property of “like kind.” Tax deference is often advantageous, however, the pros should be weighed against the cons — prior to diving into a 1031 exchange — to ensure the 1031 exchange is right for you.
The first question:
Can I benefit from a 1031 exchange?
You benefit from a 1031 exchange if you are selling investment property, or property that is used in a trade or business, and want to purchase new investment property to replace it. If this is the situation, you can sell the old property and purchase the new property without paying taxes on the sale. This tax deference is the main benefit of a 1031 exchange.
If the properties qualify, and are of like kind, the next question:
What is your basis in the relinquished property, and are the current capital gains rates favorable to a sale?
If you have a high basis in the property (basis being the difference between the price you purchased the property for and its current fair market value), then you might not want to defer taxes. It may be more tax efficient to pay the capital gains now, while rates are reasonable, on a high basis. However, if you have a low basis in the property, it is almost always more advantageous to defer the taxes and go with a 1031 exchange.
In order for your property to qualify as 1031 property for sale (the “relinquished property”), you must have held it for five or more years as an investment or in a trade or business. Once you sell the relinquished property, you have 45 days to identify new property to purchase (the “replacement property”) which also has to be intended for investment, or for a trade or business purpose. After the replacement property is identified, it must be purchased within 180 days (around 6 months) from the relinquished property’s date of sale. This is the most common type of 1031 exchange, and is referred to as a forward, delayed 1031 exchange.
There are many other types of exchanges and different iterations of the same pattern. For instance:
- You can sell multiple properties and/or purchase multiple properties.
- You can first purchase the replacement property and then sell the relinquished property — this is called a reverse, delayed 1031 exchange.
- If you know exactly what properties you want to sell and purchase, you can sell and purchase simultaneously (or close to simultaneously) through a title company, which is referred to as a simultaneous 1031 exchange.
- You can sell one property, purchase another and build improvements on it, which is called a construction 1031 exchange.
- A 1031 exchange even works for large items of equipment.
Before we continue, let’s discuss the requirements:
What are the requirements of a 1031 exchange?
- The primary principal of the exchange is: the exchangor cannot have control over, or access to, the funds during the exchange. If you have access to the funds, the exchange fails and does not qualify for tax deference.
- A 1031 exchange has to be facilitated by a qualified facilitator, which is defined in the Internal Revenue Code very specifically, but generally means anyone who is a true third party, not related to or an agent of the person performing the exchange (the exchangor).
- If you’re thinking of selling property that would qualify for a 1031 exchange, contact a qualified facilitator first, to make sure your specific property sale qualifies and to make sure tax deference is right for you, based on the property’s basis and current capital gains rates.
- The facilitator must be assigned the Purchase and Sale Agreement and must receive the proceeds of the sale of the relinquished property, and will hold the funds in trust until the exchange is complete.
- If you have already sold the relinquished property, it is too late and you will not qualify for an exchange.
Once you have engaged the facilitator and sold the relinquished property, the facilitator will enter into an agreement to purchase the replacement property, keeping in mind the two time limitations discussed above, and will use the proceeds from the sale of the relinquished property to purchase the replacement property. The replacement property is deeded directly to the exchangor. Any remaining proceeds are reimbursed to the exchangor, and will be taxable income.
These exchanges are highly technical. Any misstep of the Internal Revenue Code regulations can lead the disqualification of your exchange. JDSA has a focused, real estate legal team and regularly acts as a 1031 exchange facilitator.