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 If you've got rental property or another property used for business purposes, Section 1031 of the Internal Revenue Code has a special tax shelter in store for you. Section 1031 simply states that no gain or loss will be recognized on the exchange of property held for productive use in a trade or business, or for investment, so long as the property is exchanged for like kind.
What is a Section 1031 Tax Exchange?
That's quite a statement, and before you get too excited about other types investments, there are lots of exceptions to the Section 1031 tax exchange provision - stocks, bonds, and other securities are not eligible. But the good news is that real estate qualifies under this provision.
Under Section 1031 of the Internal Revenue Code if you sell or exchange certain types of property then you can defer a capital gain or loss. This mechanism allows you to defer paying federal income taxes on capital gains.
Tax Exchange Basics
Now we are not talking about the home you live in - your personal residence. This section of the Internal Revenue Code is talking about property used in a business setting. So the 1031 tax exchange we are talking about is for property held for investment purposes.
Exchanged properties must be "like kind." This means real property for real property, but not necessarily limited to land for land or a rental house for another rental house. The term "like-kind" is referring to personal property of the same character or nature - even if the quality of the property is different.
Basic Rules of Section 1031 Tax Exchanges
Here are some of the basic rules that apply to a Section 1031 tax exchange:
- The sale of a single property does not limit the seller from exchanging multiple properties. The reverse is also true: the seller can dispose of multiple properties in order to purchase a single property.
- If the seller does not use all proceeds to purchase the new property. The unused portion is considered a cash sale, and is taxes are paid on the proceeds.
- All of the incoming and outgoing funds involved in the 1031 tax exchange flow through a "Qualified Intermediary", sometimes also referred to as a "Facilitator."
Section 1031 allows for two basic types of exchanges: like-kind exchanges and deferred exchanges. A like-kind exchange is simply a simultaneous closing exchange in which the offered and selected properties must be similar.
The Tax Exchange Process
A deferred exchange is used more extensively in the private sector for things such as real estate investment property. A deferred exchange takes place when the cash from a property acquisition goes from the escrow to a "qualified intermediary" then the replacement property is purchased in the exchange person's name.
The replacement property must be identified within 45 days after the property purchased is recorded in the county office and then purchased within 180 days. So the process takes place in three steps:
- Property Sale - Before the sale of the first property, the person selling the property must add certain language into the Contract for Sale. Additional documentation is prepared by a qualified intermediary or facilitator. On closing, the proceeds from the sale are delivered directly to the qualified intermediary.
- Replacement Property Identification - The person that has just sold personal property must identify the replacement property within 45 days following the initial property sale. The seller usually identifies up to three potential replacement properties.
- Replacement Property Purchase - The person selling the original property now must purchase a replacement property within 180 days after the original property sale. At the closing, money is paid by the qualified intermediary and the Deed to the replacement property is transferred to the client.
That's all there is to it. The Section 1031 tax exchange mechanism allows you some flexibility in selling your real estate investments without having to worry about paying taxes - at least in the short term. Remember, Section 1031 enables you to defer paying income taxes by deferring a capital gain on the property.
So if you've made money in the real estate market, you can change your withholdings and continue to shelter any taxes due on you gains by taking advantage of the provisions of Section 1031.
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