What is a 1031 exchange

A 1031 Exchange is a tool that allows the deferment of taxes-the taxpayer can put off paying some of their capital gains taxes associated with the purchase and sale of real property. The system of 1031 Exchanges is based upon a regulation of the Internal Revenue Service, IRS Code 1031.

IRS Code 1031 permits the deferment of payment of capital gains taxes on real property (or any property subject to capital gains tax, such as stocks or bonds), at both the federal and state levels, when a property owner sells his or her property and purchases another property of "like kind" within a given time period.

"Like kind" refers to property that is in the same general category, such as an exchange of real property for real property, or stock for stock. The like kind requirement is very flexible, and not at all binding on sellers in terms of limitations on qualifying property. For example, so long as a 1031 Exchange involves a sale of an investment property and subsequent purchase of an investment property, this constitutes a qualifying exchange, even if the two properties are not otherwise similar.

A 1031 Exchange is applicable only to investment property. Investment property is property that is purchased to produce a profit, which in the real estate context often occurs through a resale of the property for a higher price than that at which the property owner purchased it for.

A 1031 Exchange requires that the like kind property be exchanged within a certain timeframe (since it is usually not logistically possible to make an exchange simultaneously). A seller of real property has 45 days from the closing on his or her initial property to nominate potential replacement properties. The seller then has an additional 135 days to acquire the replacement property, for a total of 180 days from the closing on one property to the acquisition of another like kind property during which an exchange that satisfies 1031 Exchange requirements must occur.

During this limited time period, a seller must accomplish many things to qualify for the 1031 Exchange tax deferment. 45 days is a short time during which to find an appropriate property, make an offer on that property, complete contract negotiations, and conduct a title search, survey, home inspection, and the like.

A seller is required by the IRS to hire an Exchange Accommodator, a professional who can assist a seller with the process. An Exchange Accommodator, also sometimes called a Qualified Intermediary, prepares all legal documents associated with the 1031 Exchange, as well as holding money for the seller in the exchange so that the seller does not have access to it, which would violate the requirements of IRS Code 1031. The Exchange Accommodator must be completely independent; that is, not a representative, friend, or family member of the seller involved in the exchange.

A 1031 Exchange must be prepared prior to the closing on the first property. The property seller who wishes to take advantage of the tax deferment offered by a 1031 Exchange cannot receive any funds for the property he or she is selling, either actual payment or constructive payment, which is a payment already made by the buyer of the property but not yet physically received by the property seller. The property seller, him- or herself or through a representative such as an attorney or a real estate agent, should contact an Exchange Accommodator well in advance of closing on the property he or she is selling to begin setup of the exchange.

For a 1031 Exchange to qualify the taxpayer for a complete deferment of all associated taxes, the value and the equity of the subsequently-purchased property must be the same or higher than that of the property sold by the seller. If the property purchased in the like kind exchange is lower in value than the property sold, taxes would be owed by the seller on that balance of the transaction amount.

A 1031 Exchange is a useful tool that allows an investor in real property to continue to invest in properties of ever higher value, making a profit as he or she moves from investment to investment, while deferring capital gains taxes that would normally be due.