What is a 1031 Exchange?
Section 1031 of the Internal Revenue Code provides a strategy for deferring the capital gains tax that may arise from the sale of business/investment property. By exchanging the property for other "like-kind" property, investors and business owners may defer their capital gains tax and use all of the sale proceeds to purchase "Replacement Property."
To satisfy the requirements of 1031 and defer capital gains tax, the Exchanger must assign the sale proceeds from the first investment property ("Relinquished Property") to a Qualified Intermediary ("QI") like 1031trx LLC. If the Exchanger takes possession of the sale proceeds, all tax benefits offered under 1031 are forfeited.
45-day Rule: After selling the Relinquished Property, the Exchanger has 45 days to notify their QI 1031trx LLC of potential Replacement Properties. Only these Replacement Properties will qualify for the exchange.
180-day Rule: The Exchanger must receive the Replacement Property within the earlier of (1) 180 days after the Relinquished Property was sold, or (2) the Exchanger's tax return due date (including extensions) for the tax year during which the Relinquished Property was sold.
Investment property is any property held for productive use of trade or business, or for investment. The exchanger should be able to substantiate that his or her primary intent was to hold property for investment purposes or for productive use in trade or business.
1031 is not applicable to a primary residence or a second home, unless the property was used for at least two years for rental to third parties. All exchanged properties MUST BE LOCATED IN THE UNITED STATES.
Things that are not investment property: interests in a partnership, stock in trade, property held primarily for resale, and certificates of trust/beneficial interests. Coop shares can be investment property, as an exception to the rule against stock in trade.
The rule most commonly used by real estate investors is the so called “3 Property Rule.” Under that rule, an Exchanger can identify up to 3 like-kind properties as Replacement Property without regard to value.
The second identification rule is the so called “200% Rule.” Under that rule, an Exchanger may identify any number of Replacement Properties provided that the aggregate value of all property on the identification list does not exceed 200% of the value of the Relinquished Property.
The like-kind properties must each be used for investment or business purposes, but that doesn’t mean they have to have the same exact use. An apartment can be exchanged for a office building, for example.
Examples of like-kind property that can be exchanged under Section 1031 include: apartment buildings, single family homes and apartments used as rentals, vacant land, office buildings, duplexes, warehouses, farms, utility easements, tenant-in-common (TIC) interests, etc.
Examples of non-like-kind property that cannot be exchanged under Section 1031 include: primary residences, “flips,” stocks, bonds, notes, mortgages, cash, equipment, goodwill, inventory, and interests in a partnership.
If you end up with cash to even out the value of the two exchanged properties—often called a “boot”—that cash is taxable at current capital-gains rates. A “boot” is also any property the taxpayer receives in the exchange which does not qualify as “like-kind" property.
If an exchanger does not acquire a Replacement Property with an equal or greater amount of debt, he or she is relieved of a debt obligation, which is considered "mortgage boot." The IRS considers this reduction in debt a benefit to the exchanger; therefore, it is taxable, unless it is offset by adding equivalent cash to the Replacement Property purchase.