What is a 1031 Real Estate Exchange?

Have you said any of the following to yourself?

• I'd love to sell this rental property, but I can't afford to pay the taxes.
• My accountant tells me the taxes would kill me if I sold my rental property.
• Why sell? The government will just get all the profit.
• After I sold this rental property and paid the taxes, I wouldn't have enough cash left to buy the new property I want.

If you have, then you are a great candidate for a 1031 Exchange. So, what exactly is a 1031 Exchange?
Named after Internal Revenue Code Section 1031, a 1031 Exchange allows you to defer taxes on the profit you make when you sell investment real estate. The IRS requires you to comply with a few requirements, however.

First, the old property you are selling and the new property you are buying must be rental/investment property or bare land. If you meet this test, you can sell any type of property (an apartment building) and buy any other type of property (an office building).

Second, from the date of closing on the old property, you have 45 days to identify up to three properties you would like to buy.

Third, also from the date of closing, you have 180 days to close the purchase of one of the properties you identified.

Fourth, you cannot touch the money. By law, the money must be held by a "Qualified Intermediary," a company specifically empowered to hold your money for you without you being taxed on it.

Fifth, whoever is the titleholder of the old property has to remain the titleholder of the new property.

Finally, to avoid any taxable gain, you must reinvest all your cash proceeds and buy a property of equal or greater value.

A 1031 Exchange will not complicate your real estate transactions in the least if you use a professional accommodator, and can save you many thousands of dollars in taxes.

A Section 1031 tax deferred exchange, also referred to by the IRS as a Starker Exchange, Tax Free Exchange, or Like-Kind exchange, allows an exception to the real estate capital gains tax. When you sell your business or investment real estate, replace it with a different business or investment property, and complete an exchange, you can defer payment of the capital gains tax normally required on these sales. You can also legally avoid capital gains tax on rental property capital gains tax.

Only investment real estate properties qualify for 1031 exchanges, so if you rented it to tenants, ran your business out of the property, leased it to another business, or even raw land can qualify as a 1031 exchange. As long as it is not your primary residence, you can avoid paying capital gains taxes on the sale of the property. The new property you would roll your assets into must be less than 200% of the value of the property sold.

Under normal circumstances, when you sell an investment property, you have to pay tax on the gain from the investment property sale. Investment property gains are caused by taking depreciation deductions for tax purposes, or by the property appreciating in value during its ownership.

A 1031 exchange and the Capital Gain tax rule is not a tax loophole. It is a section of the Internal Revenue Code, written by Congress, to allow anyone who meets all the requirements to sell their property and defer paying taxes on the gain.

If your plans include using the money from the sale of a business or investment property to buy more of the same, a 1031 real estate exchange provides greater proceeds for your next investment-more than you could gain through the re-investment of after-tax proceeds.

Understanding the Capital Gains Tax Rule and Avoiding the Capital Gains Tax

All relinquished (old) and replacement (new) property must be vacant land, rental property or property used for trade, business or investment. The property must be held for at least a year and a day to qualify for a 1031 Exchange. If the properties meet these requirements, you may exchange any real estate for any other type of real estate.

• You cannot have actual or constructive control of any of the proceeds received from the sale of the old property. By law, all money is held by a Qualified Intermediary (also referred to as an Accommodator or Facilitator). You cannot have an associate or employee, your attorney, broker or CPA hold the proceeds, nor can you leave the proceeds in escrow until the second property is purchased. 
• You must reinvest all cash proceeds from the sale, and purchase a new property or properties of equal or greater value, in order to avoid taxation on the gains. 
• You have 45 days from the date of closing on the old property to identify a list of properties, from which you will purchase the new property. 
• From the date of closing, you have 180 days to close on one or more of the properties from your 45-day list. 
• The titleholder on the old property must be the same titleholder on the new property.