1031 Exchanges: A Guide for Property Owners
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What is a 1031 Exchange?
Section 1031 of the IRS code allows real estate investors to exchange like-kind real properties without incurring a capital gain. The investor relinquishes one property and purchases another, but because the event is treated as an exchange rather than a sale, no capital gains tax is due on the property being relinquished. The investor pays capital gains tax only when the new property is sold and a profit is realized.
It is possible to make consecutive 1031 exchanges. In such cases, capital gains tax becomes due only after the sale of the final property, as long as the rules governing 1031 exchanges are followed for each subsequent exchange after the first one.
What Are Like-Kind Real Properties?
Prior to the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, the definition of real property was very broad. The TCJA narrowed it to exclude primary residences, properties being held for sale, stocks and bonds, and other personal property.
So, what real properties are considered “like-kind?” The IRS defines like-kind property as “property of the same nature, character, or class,” and explains that “all real property is like-kind to all real property.” In effect, if both properties—the one being relinquished and the one replacing it—meet the definition of real property and four simple eligibility requirements for a 1031 exchange, the IRS should approve them as like-kind. The four eligibility requirements are that each property:
- – Is held for business or investment purposes, not for sale
- – Is located in the United States
- – Is not a primary residence
- – Is not held by a partnership or a limited liability company (other than a Delaware Statutory Trust)
The individual properties may be quite different and still qualify as like-kind. For example, undeveloped land and land with a building on it (other than a primary residence) are like-kind. Land with a 100-year old crumbling structure on it and land with a newly constructed building are like-kind. The differences are considered to be differences in grade or quality, which do not enter into the determination of like-kindness.
That determination may seem relatively straightforward, but sometimes it can be complicated. For example, there may be issues regarding the like-kindness of mineral deposits, water rights, or gas or oil exploration rights to resources beneath the earth’s surface. If you make a mistake and your 1031 exchange is disallowed by the IRS, you could end up receiving a hefty and totally unexpected tax bill in the mail. Therefore, it’s important to consult a tax accountant or an attorney if you have any doubt as to whether the IRS will consider the properties you intend to exchange as like-kind.
Delayed Exchange Rules
It’s not always possible to find a suitable like-kind replacement property quickly enough, so the IRS permits delayed exchanges, which are also referred to as “three party” exchanges. With a delayed exchange, there must be a qualified intermediary who will hold the proceeds from the sale of the property being relinquished until the money is used to acquire a replacement property.
There are two timing rules that must be adhered to in delayed exchanges:
- 1. The 45 Day Rule requires that the intermediary be informed in writing of the specific replacement property within 45 days of the sale of the property being relinquished in the exchange.
- 2. The 180 Day Rule requires that closing on the purchase of the replacement property must occur within 180 days of the sale of the relinquished property.
The involvement of an intermediary prevents a delayed exchange from being considered a sale, because the investor never takes possession of the sale proceeds. No sale, no capital gains tax!
Multiple 1031 Exchanges
Theoretically, real estate investors can make one 1031 exchange after another for many years, as long as they comply with all IRS rules governing such exchanges. So, at what point would they sell their last remaining replacement property and get off what many have described as a “hamster wheel?” The question is, when is the best time to realize the capital gain and pay the capital gains tax? Again, it’s wise to consult a tax accountant or attorney with experience in 1031 exchanges.
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