1031 Exchange

Overview of a 1031 Exchange

A 1031 Exchange is also known as a tax deferred exchange. It is also a simple strategy and method for selling one property, that's qualified, and then proceeding with an acquisition of another property that is also qualified within a specific time frame. There are five guidelines that you need to follow when participating in a 1031 Exchange, and they are:

  • The value of the replacement property must be equal to or greater than the value of the relinquished property less any selling expense.
  • The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
  • The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
  • All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.
  • Constructive receipt of sales proceeds is prohibited during the exchange process.
  • Deadlines for identifying and closing on the replacement property must be followed.

In order to qualify for a 1031 exchange, you must exchange properties that are held for productive business or investment use only. This means that the sale of stocks, bonds, or other investments that are considered personal (including your home) do not qualify for the 1031 tax exchange. An example of an investment property would be a piece of property that you bought to make a rental property rather than your own home.

Another requirement for participating in a 1031 Exchange is that the property has to be of "like kind." A like kind property is defined as any two assets or properties that are considered to be the same type, making an exchange between them tax free. For example, you can exchangeyour car for another car tax free,but if you exchange your car for a piece of land, you could be subject to capital gains tax. Also within 45 days of closing on the relinquished property, a 1031 trader must file a list of possible replacement properties. Furthermore a second deadline occurs 180 days after the initial transaction. At that time, the exchanger must close on a replacement property.

Why a 1031 Tax Deferred Exchange

One word should come to mind when people participate in a 1031 exchange, and this word is taxes. People participate in a 1031 exchange to defer paying taxes or to avoid paying taxes all together. In a 1031 exchange, owners defer the capital gains tax they typically pay in a property sale. The 1031 Exchange accomplishes 100% deferral of capital gains indefinitely. For instance, an investor that purchases a building for $20 million and then sells it for $50 million will avoid paying taxes on the $30 million gain.