1031 (Tax-Free) Exchanges

If you are considering the sale of a highly appreciated investment property and intend to reinvest the proceeds in another investment property, a 1031 Exchange (Tax-Deferred Exchange) is a powerful tool for tax deferral.

A 1031 Exchange allows the taxpayer to sell income, investment or business property and replace it with like-kind replacement property without having to pay federal income taxes on the transaction. Taxes on the sale of the first property will be deferred, and the tax basis of the replacement property will be essentially the purchase price of the replacement property minus the gain which was deferred on the sale of the relinquished property as a result of the exchange. The gain on the sale of the relinquished property will be deferred until the taxpayer cashes out of his investment in the future.

In order to qualify for a 1031 Exchange, certain rules must be followed. The rules are, of course, complicated and must be carefully adhered to, but here is a brief summary of these rules:

1. The property being sold must be “Qualifying Property”, meaning property held for investment purposes or income-producing purposes. A primary residence cannot be used for a 1031 Exchange.

2. The replacement property must be “like-kind”, which in the case of real estate means another piece of real estate. Title must be taken in the same names as the relinquished property was titled.

3. Ideally, the replacement property should be of equal or greater value than the relinquished property. To the extent the replacement property has a lower value than the relinquished property, taxes will be owed.

4. In most cases, the services of a “qualified intermediary” are engaged. A qualified intermediary is a person who is not the taxpayer who enters into a written “exchange agreement” with the taxpayer and acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer. The qualified intermediary does not actually receive and transfer title, but facilitates the transactions in compliance with IRS regulations.

5. The exchange must be done within a particular time frame. It may be simultaneous, or the replacement property may be acquired before or after the sale of the relinquished property so long as IRS requirements are met.

6. If the relinquished property is sold first, a replacement property must be identified within 45 days from the date of the sold property, and closing must occur within 180 days from the date of sale. The intermediary will hold the proceeds of the sale until the subsequent closing occurs.

7. If the replacement property is acquired before the sale of the relinquished property, the property to be relinquished must be identified within 45 days after the acquisition, and sold within 180 days of the acquisition. The intermediary will hold the replacement property until the relinquished property is sold.

Of course, as with any transaction involving complicated tax regulations, the advice of a qualified professional should be sought. If you are selling an investment property and want to defer any taxes which would be due on the sale, consider a 1031 Exchange as an alternative.