A 1031 exchange, named after Section 1031 of the U.S. Internal Revenue Code, is a tax deferral strategy for real estate investors. It allows an investor to sell an investment property and reinvest the proceeds into a new, like-kind property without paying capital gains taxes on the proceeds from the sale.
There are several key terms in a 1031 exchange:
Like-Kind Property: The properties involved in the exchange must be “like-kind,” meaning they are of the same nature or character, even if they differ in grade or quality. Like kind real estate property means any type of investment property that can be exchanged for any other type of investment property. The basis for this requirement is the “continuity of investment” doctrine, which provides that when a taxpayer is merely continuing its investment from one real property into a similar kind of real property without receiving any cash profit from the sale, no capital gains tax on the profit should be triggered.
Real properties generally are of like-kind, regardless of whether they are improved or unimproved. Unimproved real property is considered like-kind to improved real property as the lack of improvements is a distinction of grade or quality. Real property in the United States that is held for investment purposes (a “1031 qualified use”) is “like-kind” to all other real property in the United States to be held for a 1031 qualified use. Examples of real properties that may fall under a 1031 qualified use include unimproved land, farmland, commercial, office, industrial, retail and rental properties.
Timing Rules:
Identification Period: An investor must identify potential replacement properties within 45 days of selling its original property.
Exchange Period: The replacement property must be acquired within 180 days of selling the original property.
Working with an experienced real estate attorney for investment purposes to ensure that any transaction documents provide for seller’s cooperation with the 1031 exchange and that all deadlines are met is instrumental to completing a 1031 exchange transaction successfully.
Qualified Intermediary: To facilitate the exchange, an investor typically needs to use a qualified intermediary (QI), who holds the proceeds from the sale of the original property and uses the proceeds to purchase the new like-kind property. An investor cannot access the sale proceeds directly.
Tax Deferral, Not Forgiveness: A 1031 exchange defers the payment of capital gains taxes rather than eliminating them. When an investor eventually sells the replacement property without completing another 1031 exchange, the investor will owe capital gains taxes on the profits from both the original and replacement properties.
Boot: If an investor receives any cash, payments per an installment note, reduced mortgage on the replacement property or non-like-kind property (referred to as “boot”) in the exchange, the investor will need to pay capital gains taxes on the boot amount.
Investment Properties Only: The exchange applies only to investment properties, and not to personal residences or properties used primarily for personal purposes.
A 1031 exchange is a powerful tool for real estate investors who want to upgrade and diversify their investment properties while deferring capital gains taxes. However, 1031 exchange transactions can be complex, requiring the expertise of a tax professional, qualified intermediary and experienced real estate lawyer for investment purposes to ensure compliance with all rules and regulations.
Contact an experienced real estate attorney in Vancouver, Washington and Portland, Oregon.
