A 1031 exchange, otherwise known as a tax deferred exchange is a simple strategy and method for selling one property, that’s qualified, and then proceeding with an acquisition of another property (also qualified) within a specific time frame. The logistics and process of selling a property and then buying another property are practically identical to any standardized sale and buying situation, a “1031 exchange” is unique because the entire transaction is treated as an exchange and not just as a simple sale. It is this difference between “exchanging” and not simply buying and selling which, in the end, allows the taxpayer(s) to qualify for a deferred gain treatment. So to say it in simple terms, sales are taxable with the IRS and 1031 exchanges are not.
Any Real Estate property owner or investor of Real Estate, should consider an exchange when he/she expects to acquire a replacement “like kind” property subsequent to the sale of his existing investment property. Anything otherwise would necessitate the payment of a capital gain tax. Below is a look at the basic concept, which can apply to all 1031 exchanges. From the sale of a relinquished real estate property, this concept is important so that you can completely defer the realized capital gain taxes. The two major rules to follow are:
1.The total purchase price of the replacement “like kind” property must be equal to, or greater than the total net sales price of the relinquished, real estate, property.
2. All the equity received from the sale, of the relinquished real estate property, must be used to acquire the replacement, “like kind” property.
A taxpayer who wants to complete an exchange, lists and markets property in the usual manner. When a buyer steps forward and the purchase contract is executed, the seller enters into an exchange agreement with a Qualified Intermediary who, in turn, become the substitute seller. The exchange agreement usually calls for an assignment of the seller’s contract to the Intermediary. The closing takes place and, because the seller cannot touch the money, the Intermediary receives the proceeds due the seller.
1031 Exchanges Carry Time Restrictions
At that point, the first timing restriction, the 45-Day Rule for Identification, begins. The taxpayer must either close on or identify in writing a potential Replacement Property within 45 days from the closing and transfer of the original property. The time period is not negotiable, includes weekends and holidays, and the IRS will not make exceptions. If you exceed the time limit, your entire exchange can be disqualified and taxes are sure to follow.
Once a replacement property is selected, the taxpayer has 180 days from the date the Relinquished Property was transferred to the buyer to close on the new Replacement Property. However, if the due date on the investor’s tax return, with any extensions, for the tax year in which the Relinquished Property was sold is earlier than the 180-day period, then the exchange must be completed by that earlier date. Remember, a portion of this period has already been used during the Identification Period. There are no extensions and no exceptions to this rule, so it is advisable to schedule the closing prior to the deadline.
Since the law requires that the taxpayer not touch the proceeds from the first transaction, the Qualified Intermediary acquires the Replacement Property from the seller at closing and after the transaction is completed, then transfers it to the taxpayer.
This is a basic description of how a successful 1031 Exchange works. Depending upon the taxpayer’s situation, the type of property relinquished and the characteristics of the Replacement Property, other aspects of the Exchange may be involved. Its completion may become complex and experts should always be consulted. This is no task for a “do it yourself” investor.