The Basics: 1031 Exchanges
Owners of investment real estate or business real estate may have heard the term “1031 Exchange” or “Like-Kind Exchange,” but may not understand what these terms mean or how a 1031 Exchange might be beneficial for them. 1031 Exchange or Like-Kind Exchange are interchangeable terms to describe a real estate transaction that is used to defer paying capital gains tax on the sale of business or investment property. A caveat is that the capital gains tax can be deferred so long as the seller is buying similar property in a relatively short period of time following the sale of their business or investment real estate.
Capital gains tax can be triggered if an owner is selling real estate for more than the basis of the real estate. For example, if a real estate owner purchased property for $300,000 and sells it for $1,000,000 there would potentially be $700,000 worth of gain. Based on applicable taxes, capital gains taxes and other related taxes on the sale of the real estate could range from 19% to 27%. The ability to defer that gain to a later time could result in quite a savings for the real estate owner. In order to qualify for this capital gains tax deferral, a real estate owner must follow the five basic requirements for a 1031 Exchange.
The first requirement is that the real estate owner must be exchanging property. In other words, the owner is selling one piece of property and purchasing another.
The second requirement is that both properties must be used for investment or business purposes. A personal residence would not qualify.
Meeting the timing deadlines is the third element that must be satisfied. Once the property owner has sold his property, he has 45 days to identify the replacement property and 180 days to close on the purchase of that property.
A fourth requirement is that the replacement property must be equal to or greater in value and equity than the property that was originally sold.
The last requirement is that the exchange must take place with the same taxpayer. There is some flexibility for single member LLCs, revocable trusts, and estates.
It is important for a real estate investor to decide that he wants to enter into a 1031 Exchange before he sells the real estate. The exchange documents must be signed on or before the closing of the sale of this property. A qualified intermediary will then hold the funds from the sale of the real estate until the second closing for the purchase of the replacement property. While there are several variations to the 1031 Exchange, any of these forms of Like-Kind exchange can be helpful to the real estate investor who wishes to defer capital gains tax on the sale of investment or business property.