The Facts: IRS Section 1031 Tax Deferred Exchanges

Real Estate

Now that the real estate market is picking up steam and appreciating in value, we are starting to see more 1031 tax deferred exchanges come into play. For this reason, it seems like a good idea to revisit how a 1031 tax deferred exchange works.

Section 1031 of the Internal Revenue Code allows a taxpayer to defer/postpone the payment of capital gains tax from the sale of investment/business real estate if the proceeds are reinvested into "like-kind" property. You must have held the transferred property and you must hold the replacement property for investment purposes or for productive use in a trade or business.

"Like-Kind" exchange refers to the type of property being exchanged. You can exchange any real estate investment property for any other type of real estate investment property (i.e., vacant lot for rental condominium). Your primary residence or second home does not qualify as "like-kind" investment property.

To accomplish a fully tax-deferred exchange, the rule to follow is: EXCHANGE EVEN OR UP IN VALUE AND EXCHANGE EVEN OR UP IN EQUITY.

To the extent that the taxpayer receives money or other property, they will have "boot".  To the extent that you not follow the exchanging up rule, you will have received non-qualifying "boot" in your exchange. If boot is received, tax is computed on the amount of gain on the sale or the amount received - whichever is lower.

While real estate exchanges offer excellent tax advantages, they must be structured in accordance with all IRS Regulations to realize a tax deferment benefit. In 1991, the IRS issued final regulations on how to successfully complete a tax-deferred exchange. The Regulations impose limitations on real estate exchanges and provided long overdue guidance in an area of the tax law law that is filled with traps for the unwary or the ill-advised. The paperwork documenting your disposition and acquisition transactions is critical to a successful exchange.

In a deferred exchange, you are required to "identify and designate" your new property on or before 45 days from the transfer of your relinquished property. This must be completed in writing and received by the intermediary within the 45 days.  Additionally, you must close one or more of the replacement properties you have identified and designated within 180 days of the closing of your relinquished property; or before the due date for filing your tax return for the year in which the relinquished property closed - whichever is earlier. You can always get in the full 180 days to complete the exchange if you timely request from the IRS an extension for filing your tax return. However, no extensions are given to the 45 and 180 days time constraints. 

In adherence to the IRS Regulations, you must identify and designate a replacement property in writing to your intermediary no later than the 45th day. You can identify and designate up to three (3) properties regardless of their value. Should you wish to identify more than three (3) properties, the total value of all the properties you identify cannot exceed 200% of the relinquished property's value. It is also required that the properties be located within the United States.

To meet IRS requirements, you can also never have actual or constructive receipt of the exchange funds during the exchange.  You must give up control of your exchange funds to an intermediary during the exchange period. Therefore, your choice of intermediary could be the most important decision in your exchange.

If you need a recommendation for a professional intermediary to help you with a 1031 Tax Deferred Exchange, please connect with me and I will help you. Please note that neither I nor a professional intermediary can advise you concerning the specific tax consequences or advisability of a deferred exchange for tax planning purposes. You will be advised to seek the counsel of your accountant or attorney. 


***This information provided by Real Estate Exchange Corporation***