Also known as a deferred exchange, a 1031 exchange is a tax advantage that enables businesses and investors to defer capital gains tax on real estate. Sounds too good to be true, right? Well, honestly it really isn’t. Section 1031 of the Internal Revenue Code provides a legal way to postpone the tax on the gain if the property is held as part of a business or investment. This is a great way for businesses and investors to take advantage of the additional value of their real estate and put it into their next purchase. As such, it is essentially like an interest-free loan.
Unfortunately, this doesn’t mean that you can complete a 1031 exchange on absolutely any deal. In order to qualify your exchange must meet certain requirements. This includes rules surrounding the following:
Using a qualified intermediary
The law states that for a 1031 exchange to be valid, the business or investor must use a qualified intermediary, also known as an exchange facilitator. These are experienced professionals who understand the rules surrounding a 1031 exchange and will complete it on your behalf, ensuring that your deal qualifies for tax deference.
What type of real estate you are exchanging for your existing land or property
The rules state that the replacement real estate must be like-kind in their character and use. For example, you cannot exchange a personal property for a real properly or vice-versa. However, you can exchange a rental apartment you own for a rental home. Your exchange facilitator will be happy to advise you whether your intended exchange real estate meets the requirements.
The time frame to complete your 1031 exchange
You cannot defer paying capital gains on an exchange forever. The rules state that you must nominate the property that you wish to exchange to within 45 days of the sale of your previous real estate. Similarly, you must complete your acquisition of the replacement property within 180 days.
So, to answer the question, ‘are there any downsides to a 1031 exchange’, the answer is not really. There are certainly considerations to take into account, such as the fact that when you engage in a 1031 exchange there is a reduced basis for depreciation on the replacement property. This means that the tax basis on the replacement property is essentially the purchase price minus the deferred gain on the sale of the relinquished property. This deferred gain will certainly be taxed in the future if or when you sell it without entering into another exchange.
However, since many businesses or investors move from exchange to exchange fairly seamlessly, it is possible to postpone paying tax on the deferred gain indefinitely.