What Is A 1031 Tax Deferred Exchange?

The Basics Of A 1031 Tax-Deferred Exchange

Investors often wonder what exactly is a 1031 exchange, what guidelines do they follow, and how can they legally defer their capital gains tax. Let’s find out the answers to these questions.

To begin, a 1031 tax-deferred exchange is a transaction in which one investment property is allowed to be exchanged for another like kind of equal or greater value completely tax-free, as authorized by the 1031 IRS code.

Who Qualifies For The Section 1031 Exchange?

Owners of property for investment and business purposes may qualify for 1031 deferral. Under section 1031 taxpaying entities such as C corporations, S corporations, partnerships (general or limited), limited liability companies, and trusts may set up an exchange. 

 

Guidelines For A 1031 Exchange 

  • Timeline:

The exchanger must follow the strict 45 days identifier period and the 180 days property acquirer period. Once the property has been sold, he/she has 45 days to identify the property(s) of equal or greater value at most 3 in total. At the time the identifier property has been decided. The exchanger now has 180 days (135 days from the end of the 45 day period)  from the date he/she sold their property to close on the identified property.

  • What Makes A Property “Like-Kind” In An Exchange

A property that is of “like-kind” is a piece of real estate of a qualifying form. Which means as long as the property is a piece of real estate of equal or greater value it can be exchanged. Hypothetically, an investor could exchange a piece of land for an apartment building or a duplex for a commercial property, as long as it is of  “like-kind.”

 

 

  • Property Exchanged Must Be Held For Investment: 

Both the property sold and the newly acquired property must be held for investment or business purposes. Based on this a homeowner cannot sell their primary residence and buy an investment property of equal or greater value tax-deferred and vice-versa.    
  • Debt And Equity Must Must Be Of Equal Or Greater Value:

Let’s say an investor has recently sold a $500,000 property, in which he owed $250,000 and had $250,000 in equity. When the investor goes to use a 1031 exchange he must purchase a property that is valued at or above $500,000 to defer 100% of the capital gains tax. More so, the investor must replace the old debt with new debt or additional out of pocket funds when purchasing. If the investor wants to use part of the equity and keep the other portion he/she must pay capital gains on that portion, this is a “boot.”

 

 

1031 tax-deferred exchange

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  • Qualified Intermediary and Constructive Receipt: 

A constructive receipt is when the exchanger receives cash from the sale and must pay capital gains tax. The IRS Safe Harbor Division requires the exchanger to use the 3rd party known as a Qualified Intermediary to facilitate funds. A reputable insured bonded intermediary is a must today. As well the QI cannot be your attorney, agent, broker, or CPA.

 

 

  • Risks: 

As with all real estate investments, risk plays a large factor. Investors should thoroughly understand all risk factors before proceeding on a purchase of an investment property using a 1031 tax-deferred exchange.

 

 

How Do You Report Section 1031 Like-Kind Exchanges To The IRS?

You must report an exchange to the IRS on Form 8824 (referenced below) and file it with your tax return for the year in which the exchange occurred.

Form 8824 requires:

  • Written descriptions of the properties exchanged
  • Dates of the property identified and transferred
  • Any and all relationship between parties to the exchange
  • Value of all property received both like-kind and not
  • Gain or loss on sale of other property given up
  • Cash received/pair and liabilities relieved/assumed
  • Adjusted basis of gain given up and realized gain.

One who does not specifically follow the rules for a like-kind exchange is subject to be held liable for taxes, penalties, and interest accrued on transactions.

References

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