Section 1031 of the United States Internal Revenue Code provides a method for owners of real property used in a trade or businesses, or held for investment, to defer capital gains taxes that would otherwise be due upon a sale of their property. A 1031 Tax Deferred Exchange provides a powerful wealth building tool, in that it allows the investor to benefit from the compounding effect of “rolling” ALL of their equity from one property into a larger or more expensive property. By deferring capital gains taxes, and recapture of depreciation, that would otherwise be payable upon the sale of one property, the investor has more money available to invest in a replacement property. Since there is no limit to the number of exchanges a taxpayer can complete, this strategy can be used throughout an investor’s lifetime to maximize the benefits of compounding and leverage. Many investors have implemented exchange strategies that have allowed them to parlay a modest initial investment into a high-net worth portfolio of properties within 10-20 years.
Although 1031 exchanges have been part of the U.S. tax code since 1921, popularity among real estate investors has increased significantly since a 1979 court case (Starker vs. U.S.) resulted in changes to the IRC 1031 rules, which allowed for a delay between the sale of one property, and the purchase of replacement property. Previously, 1031 Exchanges required a simultaneous transfer of ownership between the parties. Since Starker, a non-simultaneous or delayed exchange can still qualify for tax deferral, provided this the transactions follow very specific rules and time frames.
To qualify for 1031 recognition taxpayers must identify the transaction as an exchange prior to closing escrow on the relinquished property and select a qualified intermediary to facilitate the transaction. The seller must follow specific procedures for identifying potential replacement property within 45 days from closing on the sale, by providing the intermediary with a written description of the replacement properties, the number and value of which are limited by IRS guidelines. The exchange must be completed within 180 days after the transfer of the relinquished property or the due date of the taxpayer’s federal tax return for the year in which the property was sold, whichever is earlier. Other specific rules and regulations apply, including the requirement that the relinquished and replacement properties be “like-kind” (i.e. investment or business real estate, including both improved property and vacant land). In order to fully defer taxes on the sale it is also critically important that the taxpayer never takes constructive receipt of any cash proceeds from the sale, nor can they realize debt relief.
While 1031 Tax Deferred Exchanges are one of the most powerful tools available to help investors manage their assets for maximum benefit the rules must be followed faithfully or the exchange will be disqualified and taxes will become due.
