What Is a 1031 (Tax-Deferred) Property Exchange?

Section 1031 of the U.S. Internal Revenue Code (IRC) allows investors to defer capital gains taxes on the exchange of “like-kind properties.” A “1031 exchange” is a method for deferring capital gains tax on a real estate transaction. Also known as “tax-deferred exchanges,” 1031 exchanges hold great advantages for all types of real estate investors.

To make sure you comply with U.S. tax laws, talk to an experienced real estate lawyer for legal advice. A real estate lawyer can explain the laws on exchange properties and make sure you comply with state and federal laws.

What Is a Like-Kind Exchange?

Like-kind exchanges are truly one of the best tax deferral options for real estate investments. However, you have to keep trading up on property values to avoid taxation. For example, if you bought a property that cost $100,000 and it has increased in value to $250,000, you have a $150,000 income tax gain if you sell the real property. For an exchange of property worth $250,000, you defer the gain on the greater value.

The real tax benefit kicks in when you swap one investment property for another. While there are specific guidelines that cover each type of transaction, there are some general rules to follow:

• The exchange must be like-in-kind. For example, this would be exchanging a business property for another business property. This standard can be surprisingly liberal. An experienced real estate lawyer can help you negotiate the exchange process.
• If the replacement property is identified and available and the owner wishes to acquire your property, the exchange may be a simultaneous swap of the relinquished property for the replacement property.
• If the replacement property is not identified when you sell the relinquished rental property, you have 180 days to close on the new property. A third party holds the property sale proceeds until used to buy the replacement property.
• Within 45 days of the sale of your relinquished property, you must designate the potential replacement properties. You then have 135 days to close.

What Are the Tax Advantages of Exchanging?

You can eliminate paying any capital gains taxes. You can also eliminate paying the higher ­rate taxes on the recapture of depreciation you’ve taken on your property. By exchanging into a higher-priced property, you’ll also gain additional depreciation deductions, which can increase your after-tax income.

By simply following the tax code section 1031 exchange rules every time you sell one or more properties and buy replacement properties, you can continue to defer taxation. When you die, your estate will escape the capital gains taxes forever.

Can I Buy a New Property Before Selling My Old One?

Yes, you can buy a new property before selling the old property and still qualify. This is a reverse exchange. A qualified intermediary takes title to the new property and holds it for you until you sell your old property.

Are There Reasons To Exchange Other Than Tax Advantages?

There are many non­tax reasons to exchange. For example, if you no longer like managing property, you can exchange your management-intensive property for a management-free property. You can also exchange multiple smaller properties for one that can be professionally managed.

In some situations, you may want to exchange out of one property for a new property, which could be refinanced more easily. Or, you might exchange to improve cash flow.

What Kind of Real Estate Qualifies for a 1031 Exchange?

Almost every kind of real estate is like kind and can be exchanged for any other real estate. This includes vacant land for a rental property. Many property exchanges qualify as long as you hold them for investment or business use.

You can acquire any number of replacement properties. You can also sell any number of smaller properties and trade up to a larger one of the same type of property. However, there may be limits on personal-use properties like vacation homes.

What Is a Qualified Intermediary?

The IRS says if you touch the money, you pay the tax. However, if you use a qualified intermediary to transfer the money from the sold property into the purchased property, you qualify for a tax-free exchange. The IRS does not permit your accountant, lawyer, or escrow company to be your intermediary. Qualified intermediaries are members of the Federation of Exchange Accommodators and are bonded.

The IRS doesn’t allow a person to act as both your qualified intermediary and your attorney or tax advisor. So, work with your attorney and CPA to make sure your tax-free exchange goes smoothly.

Can I Refinance Without Blowing the Tax-Free Exchange?

Yes, you can refinance the property you are selling before you exchange or refinance the property you are buying after you exchange, and the proceeds are tax ­free. Check for the details, as the timing and contract dates are critical.

How Can a Real Estate Lawyer Help?

A real estate lawyer can give you legal advice on making a 1031 exchange agreement and complying with federal tax laws. Contact an experienced real estate lawyer to talk about your legal options.