A 1031 exchange, also known as a like-kind exchange, is simply an exchange of one investment property with another while deferring the capital gains tax. Usually, when you invest in property, it appreciates over time. During the time of sale, capital gains tax applies on the sale’s gain. But when you execute and meet the requirements of a 1031 exchange, you defer the tax at the time of the exchange.
Furthermore, you are not limited to the number of 1031 exchanges you can execute. Therefore you can roll over the gain from one 1031 exchange to another as you profit on every exchange. That way, you avoid paying the capital gain tax until you sell for cash in the future.
However, special rules apply in a 1031 exchange which we discuss below.
The exchange should be between like-kind property.
One rule of a 1031 exchange is that it must be between like-kind property. So what is the definition of like-kind property according to the IRS? The IRS stipulates that the exchange must be between investment property. In real estate investments, a like-kind property is also an investment property in real estate. For instance, you can swap a commercial building for several rental buildings in the same or different city.
Taking control of the cash from the property sale can disqualify the exchange.
One of the rules of the IRS in regards to a 1031 exchange is that you should hire a qualified intermediary to facilitate the exchange. Note that you can disqualify the entire transaction and make all the gain taxable if you touch any proceedings from the sale.
All equity from the old property should be transferred to the replacement property.
The IRS also states that all the basis that is the amount you paid for the replacement property and improvements should be equal to the basis of the old or relinquished property minus any funds you receive plus any gain from the transaction. According to the Delaware statutory trust 1031, calculating your tax basis and estimating your tax liability requires professional expertise.
You should identify a replacement property within 45days
Another rule is that the IRS permits you a window period of 45days to identify a replacement property from the date of the sale of the relinquished property. It also states that the identification should be in writing, signed, and delivered to a qualified intermediary or seller of the replacement property. As such, a notice to your attorney or acting agent is not sufficient.
You must complete the exchange within 180days or by the date your income tax returns are due.
The IRS also requires that you receive the replacement property and complete the exchange within 180days from the sale of the old property or by the date your income tax return is due. The latter is in regards to the same tax year you sold the property. Note that this rule applies to the date that is earlier.
The last words
Having a qualified expert is critical during a 1031 exchange. Any slight mistake can disqualify your tax benefits, so you must follow all the rules to the latter.