A properly structured 1031 exchange allows investors to sell a property and reinvest the proceeds in a new property while deferring all of the capital gains tax. This allows them much greater financial growth than if they were to simply buy and sell properties.
IRC § 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
What types of properties qualify for 1031 exchange? To qualify, the property being sold and the new replacement property must both be held for investment purposes or for productive use in a trade or a business. They must be “like-kind” properties. As a usual rule, your personal residence or vacation home does not qualify. Neither do properties purchased to flip nor land for development or any type of property purchased for resale. Exceptions to this may be found in the tax code. For this reason it’s best to consult a professional.
The transaction also must take the form of an exchange. This does not necessarily mean that you must find someone to trade properties with. Most exchanges are structured like any other sale and purchase. However, the newly purchased property must have a value equal to or greater than the one that was sold. All of the equity must be used in the purchase of the new property and the financing must be equal to or greater than that of the property sold.
The tax payer has 45 days to identify the new purchase and 180 days to complete the exchange. In other words, they must purchase a replacement property with the proceeds from the sale within that time.
The exchange does not need to be a complete one. If the tax payer decides they would prefer to purchase a property of lesser value than the one they sold, the IRS will apply the capital gains tax to the portion not invested in the newly purchased property.
The proceeds from the sale must be placed with a qualified intermediary which will complete the exchange within the 180-day period. This is a neutral third party that has not had an existing business relationship with the taxpayer within the past two years. While banks and title companies offer these services, an independent qualified intermediary is recommended. It’s as important to do your due diligence when selecting an intermediary as when purchasing your properties.