If you are a business owner or investor considering selling real estate, it is important to understand how a like-kind exchange under Section 1031 of the Internal Revenue Code (IRC) can help you defer capital gains taxes. Commonly referred to as a “1031 exchange,” this economic tool allows you to reinvest proceeds from the sale of one business-use property into a “like-kind” property without immediate tax consequences.
In this post, we break down the fundamentals of 1031 exchanges, including what qualifies, how the process works, and what to watch out for.
What Is a 1031 Exchange?
A 1031 exchange is a tax-deferral strategy that allows individuals and business entities to postpone paying capital gains tax on the sale of real estate if the proceeds are reinvested into another qualifying property. It is important to note that while the tax is deferred, it is not eliminated. Taxes will eventually be due when the replacement property is sold, unless it too is exchanged in another qualifying transaction.
Who Can Use a 1031 Exchange?
A variety of taxpayers can take advantage of a 1031 exchange, including:
- Individuals
- Corporations (C Corps and S Corps)
- Partnerships and LLCs
- Trusts
The key requirement is that the properties involved must be held for investment purposes or for productive use in a trade or business.
What Property Qualifies?
To qualify for a 1031 exchange:
- Both the relinquished property (the one you are selling) and the replacement property (the one you are buying) must be real estate held for business or investment purposes.
- The properties must be of “like kind,” meaning they are of the same nature or character.
- For real estate, most property types qualify as like-kind to one another, such as:
- Raw land for a rental property
- A single-family rental for a commercial building
- A farm for a shopping center
- An easement for an oil/gas/mineral interest
- For real estate, most property types qualify as like-kind to one another, such as:
- U.S. property can only be exchanged for other property within the U.S.
Personal residences, vacation homes, and property held for resale (such as fix-and-flip inventory) do not qualify.
How Does the Process Work?
There are several forms of like-kind exchanges, but the most common is the deferred exchange.
Here is how it typically works:
- Sell the Relinquished Property: You enter into a sales agreement for the relinquished property that properly references the intent to use a 1031 exchange and a qualified intermediary, as referenced below, and close on the sale in accordance with 1031 regulations.
- Engage a Qualified Intermediary (QI): Before closing, you must hire a QI to facilitate the exchange. The QI will hold all the sales proceeds to avoid “constructive receipt,” which would disqualify the exchange.
- Identify Replacement Property (Within 45 Days): You must identify one or more potential replacement properties in writing within 45 days of selling the relinquished property and submit the identification to your QI or another qualified party.
- Purchase Replacement Property (Within 180 Days): You must close on the new property within 180 days of the sale of your relinquished property or by your tax filing deadline (including extensions), whichever is earlier.
- Report to the IRS: The exchange must be reported on IRS Form 8824 and filed with your tax return for the year in which the transaction occurred.
Important Rules and Requirements
- No Cash or Boot: To fully defer taxes, you must reinvest all proceeds and avoid receiving any cash or non-like-kind property such as personal property (called “boot”). If you receive boot, you will have to pay the appropriate capital gains tax on it.
- Title Must Match: The name/title on the replacement property must match that of the relinquished property. This means that you (or your entity that owned and sold the relinquished property) must be the party that purchases and owns the replacement property.
- Use a Qualified Intermediary: The IRS requires the use of a QI to hold funds between the sale and purchase. Your attorney, real estate agent, or accountant typically cannot serve as the QI if they have represented you in the last two years.
- Watch the Clock: Missing the 45-day identification or 180-day acquisition deadlines will disqualify the transaction.
- Beware of Related Party Transactions: Exchanges involving related parties (family members or companies, partnerships, or trusts that you control) are often not qualified for a 1031 exchange and are subject to additional scrutiny and restrictions if allowed.
Benefits of a 1031 Exchange
- Defer capital gains taxes
- Reallocate real estate investments
- Consolidate or diversify holdings
- Increase cash flow or upgrade to more desirable properties
Potential Pitfalls
- Improper handling of proceeds (constructive receipt)
- Engaging an inexperienced, unqualified or untrustworthy intermediary
- Missing identification or closing deadlines
- Failing to meet like-kind requirements
Conclusion
A Section 1031 like-kind exchange is a valuable tool for real estate investors and business owners looking to defer taxes and grow their portfolios. However, the rules are strict, and missteps can lead to unintended losses or tax consequences. If you are considering a 1031 exchange, it is crucial to work with qualified legal and tax professionals to ensure your transaction complies with IRS requirements.