The concept of a 1031 exchange is relatively simple: Reinvest the proceeds from the sale of a business or investment property into a like-kind investment in order to defer paying capital gains tax. It's one of the most popular sections in the Federal tax code because it allows owners of rental, commercial or other business real property to save significantly.
1031 exchanges allow real estate investors to defer paying capital gains tax when the proceeds from real estate sold are used to buy replacement real estate. However, the Internal Revenue Code outlines specific steps investors must follow to qualify for a 1031 exchange. You can find these steps on the IRS website .
A few key points to know:
- When you sell your existing investment property, you'll want to work with a qualified intermediary. A qualified intermediary may be a CPA with 1031 experience, a real estate attorney, a bank or a 1031 Exchange Company (qualified intermediary).
- Proceeds from the sale must be held in escrow by a third party, then used to buy the new property; you cannot receive the proceeds, even temporarily.
- Real estate must be used for investment or business purposes.
- Real estate exchange must be “like-kind”, meaning they must be of the same nature, character or class, as defined by the IRS.
- If used correctly, there is no limit on how frequently you can do 1031 exchanges.
- Replacement property must be identified within 45 days and purchased within 180 days.
- 1031 exchanges can be used even if there is a mortgage on the property.
- A property within the U.S. may only be exchanged with other real estate within the U.S.
The bottom line, 1031 exchanges give real estate investors the option to postpone paying capital gains tax when the revenues from sold property are utilized to purchase new property. In the event that you exchange one investment property for another, it might assist you to reduce your tax liability. To prevent a hefty tax charge, make sure you're strictly adhering to the IRS standards. If you have never tried a 1031 exchange, you will first want to discuss it with a tax professional.