When it comes time to sell a business or investment property, real estate owners must consider significant taxes on gains against any profit. However, if the plan is to re-invest in another property, Section 1031 of the U.S. tax code provides a welcome relief. A 1031 like-kind exchange allows a real estate owner to essentially “exchange” property – selling one and purchasing another – while deferring capital gains or losses and other taxes on the sale when they meet specific conditions. While “tax deferred” does not equal “tax free,” future taxes can be delayed if exchanges are possible and done correctly. To help our clients, prospects and others understand the basics of a 1031 exchange, JLK Rosenberger has provided the key information below.
Section 1031 Key Details
- Property Type – To meet 1031 requirements, most exchanges must merely be of “like kind,” although this phrase isn’t as rigid as you may think. Virtually every type of property can qualify under Section 1031 regulations. With a few exceptions, you can exchange business equipment for another, a plot of land for an apartment building or even a farm for a strip mall. The main rule is that both properties must be used for business or investment purposes only.
- Replacement Property Designation – It is customary for one specific property to be identified as the replacement for the original, but you can actually designate more than one. If you need time to choose from a few options, a maximum of three potential replacement properties can be identified, no matter what the fair market value of the properties are – as long as you eventually close on one of them. Another option allows you to identify as many properties as you wish as long as the fair market value is no more than 200% of the fair market value of the sold property. Whichever method you use, the designated replacement(s) must be identified in writing and include a physical and legal description of the property and the address.
- Intermediary – Section 1031 rules are very clear about the use of an intermediary. The intermediary is typically the one who will receive the proceeds from the sale of the original property, which he or she will then use to purchase the replacement property. If the previous owner directly handles the money from the sale, it negates the 1031 treatment. The intermediary is also the one who will be sent the information on the replacement property that will complete the exchange.
- Important Deadlines – Assuming that the property exchange doesn’t occur as a literal “swap” or at least on the same day, which is unlikely, there are two key timing rules you must observe in a delayed 1031 exchange. First, you must designate replacement property in writing to the intermediary within 45 days of the original property sale. You must also close on the new property within 180 days of the sale. The two time periods run concurrently, which means if you wait until the 45th day to designate replacement property, you’ll only have 135 days left to close on that property. It’s important to be aware of these key deadlines because extensions are only rarely granted for circumstances beyond control (like a natural disaster).
- Proceeds Are Taxed – Be aware that downsizing may result in a tax liability. Any cash left over after you acquire the replacement property will generally be taxed as a capital gain. For instance, if the previous property had a mortgage of $1 million and the exchange property mortgage is only $900,000, $100,000 will be considered gain and is subject to tax.
When executed correctly, a 1031 exchange is a valuable tax tool for business owners and investors that can increase your rate of return on certain property transactions. However, it’s important to work with an experienced provider to guide you through this complex process. If you have questions about 1031 exchanges or would like assistance implementing one, JLK Rosenberger can help! For additional information please call us at 949-860-9902, or click here to contact us. We look forward to speaking with you soon.