What You Need To Know About 1031 ExchangesFor those real estate owners and investors who know how to use it properly, the 1031 exchange can be one of the most powerful financial weapons. Named for the section of the tax code under which it is found, the 1031 exchange allows real estate buyers to defer de·fer 1
v. de·ferred, de·fer·ring, de·fers
1. To put off; postpone.
2. To postpone the induction of (one eligible for the military draft).
v.intr. the taxes due when they make a qualified exchange of real estate.
The 1031 exchange is also sometimes referred to as the like-kind exchange, and in fact the purpose of this program is to allow buyers to exchange one income producing or investment property for another similar property.
The 1031 exchange allows real estate owners to defer some or all of the capital gains taxes resulting from the sale of an investment property. In order to take advantage of this program, the buyer must use a qualified intermediary The Qualified Intermediary (also known as an Accommodator) should be a corporation that is in the full-time business of facilitating 1031 exchanges. The role of a QI is similar to, but not identical to, the role of an escrow company. , they must follow the guidelines guidelines,
n.pl a set of standards, criteria, or specifications to be used or followed in the performance of certain tasks. established by the IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. , and they must use the proceeds of the property sale to purchase a similar investment property within 180 days of the original sale date.
In order to be eligible for the full 1031 exchange benefit, the replacement property must be of equal or greater value as the property being sold, and it must carry an equal or greater amount of debt as the property that was sold. This rule can be waived if the taxpayer adds cash to the deal in order to replace the debt. All proceeds from the sale of the original property must be used in the acquisition of the replacement property in order to qualify for the benefits of the 1031 exchange.
In addition, the taxpayer must assign the interest in the original property to a qualified intermediary before the closing of the sale. This ensures that the taxpayer has relinquished re·lin·quish
tr.v. re·lin·quished, re·lin·quish·ing, re·lin·quish·es
1. To retire from; give up or abandon.
2. To put aside or desist from (something practiced, professed, or intended).
3. control of the funds prior to the actual sale.
After the closing of the original property, the proceeds will be sent to the qualified intermediary by the closing agent. This intermediary Intermediary
See: Financial intermediary
See financial intermediary. will retain control of the funds until the transaction for the replacement property is ready to close. The proceeds from the sale of the original property will then be deposited to the purchaser by the qualified intermediary. The funds will then be delivered to the taxpayer, completing the tax free 1031 exchange.
The advantage of the 1031 exchange is obvious to real estate owners and investors, and this provision of the tax code has become quite popular in the years since it was originally introduced. The idea behind the 1031 exchange is that the taxpayer should have the ability to sell one investment property and freely exchange it for a like property without being burdened with capital gains taxes. Since the funds derived de·rive
v. de·rived, de·riv·ing, de·rives
1. To obtain or receive from a source.
2. from the original property are never actually received by the taxpayer, the theory is that there is no taxable transaction Taxable transaction
Any transaction that is not tax-free to the parties involved, such as a taxable acquisition. and thus no taxes are due.
The provisions of the 1031 exchange have opened up many new avenues for owners of income producing properties and real estate investment properties. Those investors and real estate owners who own investment property no longer need to feel trapped in a property that did not work out the way they had hoped. Instead those investors now have the ability to more easily exchange a less than suitable investment property for a property with more cash flow or capital appreciation opportunity. This provision of the income tax code has certainly opened up new avenues and new opportunities, and it is easy to see why the 1031 exchange has become such a popular choice for real estate owners and investors.