Section 1031 of the U.S. Internal Revenue Code became law in 1921. A 1031 Tax Exchange allows investors to defer or avoid capital gains taxes on the exchange of Real Estate or Property. IRC 1031, or tax-deferred exchanges hold great advantages for investors: Increase Net Worth: an investor can replace properties that have maximized their growth potential with properties that have not yet reached their maximum growth potential. Increase Cash Flow: Sell unproductive bare land with no tax and buy a cash flow rich commercial property. Consolidate Holdings to Ease Management Burdens: Sell multiple properties with no tax and buy a single property. Diversify Risk: Sell a single property with no tax and buy several smaller properties. Sell a Second Home or Vacation Resort Property That’s No Longer Needed: Sell properties that are no longer used with possibly no tax liability.
A personal residence does not qualify for an exchange since it is used for personal use and not investment. A vacation home might qualify if the main intent is for the home is for investment in using it as a rental. Bare land, a farm, timber & mining rights, developed lots held by an investor for investment, commercial buildings such as an office, motel, warehouse or self-storage do qualify. Both the old property and the new property have to be property held for investment or used in a trade or business. One rental property can always be exchanged for another rental property. This is why you can sell a rental duplex and buy an office building. Bare land is pretty much always investment property and can be exchanged for a rental property or visa-versa. Renting property is not the only example of a transaction that will classify a property as one held for investment -- trying to rent the property also counts. Keep proof of your rental attempts such as ad receipts in case the IRS should audit you or question your motive in selection of the property. Reverse exchanges involve purchasing replacement property before selling the relinquished property. A construction exchange may be used to build a replacement property. In a construction exchange the qualified intermediary would set up a LLC and buy the land. What is going to be built on the land must be identified by attaching plans or stating for example- an 8000 square foot building. After completion the QI sells the land and improvements to the client.
Timelines: From the closing on the sale of your property you have 45 days to identify the property to be purchased. You have 180 days from the date of sale to purchase the new property.
A middleman called an "accommodator" or "qualified intermediary or QI," must be used. This is crucial because if a 1031 participant has access to the funds during the exchange, it becomes a “sale” and you owe tax. The QI is not in the chain of title on the HUD1 settlement statement but the QI may be listed as seller. A good QI is bonded, very experienced, has a lot of advice, ideas and creative approaches to exchanges. Look for membership in the Federation of Exchange Accommodators (FEA) and for the Certified Exchange Specialist (CES) designation. Always find someone who specializes in 1032 to help you when it is time, we are not an authority on the topic.
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