A 1031 exchange takes its name from section 1031 of the U.S. Internal Revenue Code. This code enables investors to avoid paying capital gains tax on investment property when it is sold. However, for this code to be applicable, investors must re-invest the proceeds from the sale, including profit, into a ‘like-kind’ property. There are also a variety of other rules that must be adhered to in order for the code to be applicable and for you to defer paying capital gains tax on the proceeds of your sale.
Since the process of a 1031 exchange can only be completed by a licensed facilitator, your chosen professional is your best support when it comes to ensuring that all areas of your transaction fall within the rules. In the meantime, here are some of the most important rules that you will need to pay close attention to when you are lining up your 1031 exchange.
Timescales for completing a 1031 exchange
From the time of closing on the property that you have sold, also known as the relinquished property, you have 45 days in which to nominate your potential replacement property. This must be done before midnight on the 45th day. Your acquisition of the replacement property must then be complete within 180 days of the closing date.
Finding a like-kind property for your 1031 exchange
The key requirement of a 1031 exchange is that your replacement property be ‘like-kind’. However, there can be some confusion as to what exactly constitutes a like-kind exchange. The most basic facet is that you cannot exchange a personal property for a real property, or vice versa. The two properties must fall into the same category. The properties must also be like-kind in their character and use. A residence can be exchanged for another residence, for example a single-family rental property can be exchanged for an apartment building. Property that has previously been used in a trade or business must be exchanged for one that will be used in the same way.
Replacement property price
The rules of a 1031 exchange state that when it comes to the price of the replacement property you are purchasing, it must be equal to, or greater than, the sale price of the property that you are relinquishing. This includes the price of the replacement property and all costs of its acquisition, while the sales price of the property you are relinquishing will be calculated after the deduction of sales expenses.
Taking equity out of your 1031 exchange
Although a 1031 exchange is designed to enable you to transfer all of your profit from your existing property to another, this doesn’t mean that it is impossible to cash out some of your equity. There is one way of doing so, and that is by opting for post-exchange financing. However, this shouldn’t be undertaken until after you have filed your closing statement with the IRS to show that you initially re-invested all of your equity into your new purchase. You can then re-finance your property via a loan or mortgage taken out against it and use those funds as you need to.
Conclusion
You cannot carry out a 1031 exchange by yourself. This is because the funds received must be held by an intermediary, and the intermediary must then use them to purchase the new, like-kind property on your behalf. A qualified intermediary or exchange facilitator must be used. Failure to do so could mean that any gain from the sale of your real estate is liable for capital gains tax.
