NOTE: This blog is not intended to provide or offer financial or tax advice. If you are looking to utilize the 1031 tax code it is highly recommended that you consult your tax professional or a qualified 1031 intermediary for assistance and clarification as to your specific use.
In dealing with farm and conservation land transactions, commercial real estate transactions and investment real estate transactions the 1031 tax code is mentioned often by our clients. Most real estate owners and investors have heard of the 1031 Exchange code but few really understand what it is, its benefits or how to property utilize the 1031 exchange without getting themselves into trouble with the IRS.
Under Section 1031 of the United States Internal Revenue Code (26 U.S.C. § 1031), the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due.
The spirit of the 1031 tax code was to give an incentive to real estate investors to re-deploy their investments from one real estate holding to the next, otherwise upgrading their overall investment, without being penalized on their capital gains.
The beneficiary of a 1031 exchange does not avoid paying capital gains altogether. They are simply deferring that taxation of that gain as long as they redeploy to the proceeds into another like-kind investment. When the 1031 exchange beneficiary eventually goes to “cash-out” which in some cases can be several transactions down the road, then the capital gain is assessed on the gain dating back to the original investment.
Here are some of the highlights of the 1031 Exchange:
- Property must be a “Like-Kind Exchange” – This is a fairly broad term but it does have some obvious conditions. You can exchange farm land for a business. For example, the 1031 Exchange allows for an investor who is selling farmland to re-deploy those funds into the construction or purchase of a residential apartment complex say in a college town. It is a very common misconception that if you sell farmland you can only reinvest the proceeds into another piece of farmland or if you sell a commercial property you can only reinvest into another commercial property. The new investment must simply be a like-kind exchange which is broad enough to cover most any investment or income producing real estate.
- You CANNOT Reinvest Sale Proceeds Into Your Personal Residence – This is one of the biggest no-no’s and attempting the reinvest sale proceeds into your personal residence will usually lead to significant trouble with the IRS. The 1031 Exchange does not allow you to sell your primary residence and reinvest the proceeds into your new primary residence.
- Timing is IMPORTANT – Within 45 days of selling the original property, you must identify a suitable replacement property or multiple properties. The property you are reinvesting the proceeds into must be fully purchased/closed within 180 days of the original sale date or before the date your tax return is due, whichever is first, during the same tax year in which you are to recognize this tax advantage.
- Use a “Qualified” Intermediary to Facilitate Your Transaction – To properly qualify under that 1031 Exchange rules, an investor may not have access to utilize the funds for the transfer. The use of a Qualified Intermediary, who will facilitate the 1031 Exchange and hold the proceeds, is the only way to keep the transaction legal and ensure that the rule of the transaction are properly executed. This qualified intermediary will hold the funds while the replacement property is found and closed, and they will prepare the legal documents necessary for the investor to file with the IRS. An intermediary cannot be a related party to the investor.
For more information about utilizing a 1031 Exchange with your next business, investment or land transaction contact a trusted tax professional or a qualified 1031 Exchange Intermediary before you go to sell your real estate holdings.