A 1031 exchange allows real estate investors to defer paying capital gains taxes when they sell a property. There’s a condition that they must reinvest the proceeds into another “like-kind” property.
Essentially, this is a swap of one investment property for another, which can help investors grow their real estate portfolios. It allows them to delay taxes that would normally be due upon sale.
How a 1031 exchange works
Imagine someone owns a small apartment building that they decided to sell. Normally, if someone makes a profit from the sale, they’d have to pay taxes on the gains. However, if they use a 1031 exchange, instead of pocketing the cash and paying taxes. In that case, they identify another property, such as a larger apartment complex, and use the proceeds from the sale of their initial property to buy the new one. By doing this, they can defer paying taxes on the profit as long as they follow certain rules.
Strict rules of a 1031 exchange
There are a few strict rules that govern the 1031 exchange. These are set by the Internal Revenue Service (IRS).
- Like-kind property means the new property must be of the same nature, character or class as the one being sold. This means any real estate used for business or investment can be exchanged for any other real estate used for business or investment.
- There are 45 days from the sale of the original property to identify potential replacement properties in writing to a qualified intermediary who holds the proceeds from the sale. Then, there’s a total of 180 days from the sale of the original property to complete the purchase of the new property.
- To fully defer paying any taxes, the new property you purchase must be of equal or greater value than the one sold. Additionally, all of the proceeds from the sale of the original property must be invested into the new property.
- The IRS requires the use of a neutral third party, known as a qualified intermediary (QI), to handle the exchange. The seller can’t receive the sale proceeds directly; the QI must hold them until they are used to purchase the new property.
The legal aspects of a 1031 exchange can be complex. Bringing in a legal representative to assist with these situations can help to make the process less stressful and more successful.