Section 1031 Exchange Rules
What Is a Section 1031 Exchange? The Rules & What You Need to Know
The first thing you need to know is that a Section 1031 exchange isn’t for everyone. By that, I mean there are many situations where doing one just doesn’t make sense. Having said that, let’s take a look at the definition and what it does.
Even though, a 1031 exchange can be very complicated, for many, there are major tax advantages to it. For instance, you may have a parcel of real estate that you want to sell, but in doing so, it will generate a big profit and a big tax bill. In this case, a 1031 exchange might be a good option for you.
Just what is a Section 1031 exchange?
This terminology comes from section 1031 of the US Internal Revenue Tax Code. The main purpose is to defer capital gain tax on the sale of an investment property or a business. This is done by taking the money from the sale and using it to buy a similar or “like-kind” property.
How is a Section 1031 exchange done?
If you don’t want problems with the IRS or worse yet, have the transaction nullified and have to pay taxes now, engage the services of a competent, experienced attorney. IRS Publication 544 explains the rules and other important details, but we’ll show you the steps to take.
Step 1. The first step is basic, and that is to decide on which property you plan to sell. Keep in mind that a Section 1031 exchange is mainly for investment or business property. If you’re thinking about using this option for personal property, like your home or a vacation property, it’s not allowed.
Step 2. You need to select the property that you intend to purchase. Remember, too, these two properties must be like-kind per the IRS rules. That means that they have to be of the same nature, class or character. They don’t have to be the same grade or quality. Plus, a property located inside of the U.S. isn’t considered to be like-kind of one located outside of the U.S.
Step 3. This step is critical. You need to select an intermediary who is also known as an exchange facilitator. Their job is to hold the funds in escrow until the entire exchange is completed. If the proceeds of the sale were to come directly to you, the Section 1031 exchange is dead.
In that case, capital gain taxes could not be deferred, and would be due in that tax year. Be very careful in selecting the intermediary. This is usually an experienced attorney in 1031 exchanges, but he can’t be your personal attorney. (more on this later)
Step 4. Now, you must decide how much of your property sale you want to invest in the new property. You’re allowed to invest all or just part. Just remember, that any amount of the sale proceeds that you don’t invest in the new one, is subject to capital gain taxes in that tax year – no deferment!
Step 5. At this time, you have two deadlines to meet, and if you don’t, no Section 301 exchange, and all gains are taxable now. So, make sure your intermediary is also aware of these dates as well.
The first deadline is that you have 45 days from the date of the sale of the first property to select the property that you plan to buy. This must be done in writing, so be sure the intermediary you hired has a copy of it. I also suggest that the seller of the other property be given a copy too.
The second deadline is that you have to buy the new property within 180 days after the sale of the first property, or after the due date of the filing of your tax return, whichever is the earliest.
Step 6. This step is a follow-up of step 3. The whole idea of a Section 1031 exchange is to defer the tax on the sale of your property, so, if you take possession of the sale proceeds, even for 1 day, the 1031 exchange will be disqualified.
Step 7. The IRS must be notified of the transaction, and this is done by completing Form 8824, and attaching it to your tax return. This tax form gives the IRS all they need to know so your 1031 exchange is approved. If you don’t file that form, you’ll soon be completing Form 4797 that is used to pay your capital gains tax now, instead of later.
Rules, requirements, and qualifications of a Section 1031 exchange
Just to be perfectly clear in a 1031 exchange, income taxes still have to be paid on the sale of the old property. Instead of paying them now, you get to pay them at some later date when the new property is sold.
Plus, not any type of property is eligible. One of the main rules is that it’s used mainly for investment or business property. Your residence, a vacation home, and most types of personal property will not qualify.
It’s not necessary that the properties being exchanged have to be as identical as it sounds. You don’t have to be swapping rental properties or even a parking lot for another one. The term like-kind means that you’re selling one investment type of property for another investment property. Make sure that the intermediary you hire reviews everything & approves it.
The limitations of the 1031 exchange rules doesn’t only cover real estate or land. Some types of personal property like cars or trucks may be eligible. Simply put, you aren’t permitted to swap real property for personal property because they are not like-kind.
Relationships not permitted
When you select your 1031 exchange intermediary, be aware that he can’t be related to you, or be your personal attorney. It also prohibits you in choosing your banker, accountant, real estate agent, or an employee. Plus, the person you choose who may have served you in one of the above capacities in the last 2 years is not allowed. And no, you can’t be your own intermediary either.
When you invest in real estate, it doesn’t mean that you have to buy property outright. There are options available that will allow you to get in the business and let you profit from this industry. Here are 3 options for your consideration.
3 Types of Section 1031 exchanges
The simultaneous exchange
In this type of exchange, the buyer and the seller will exchange the properties at the same time.
A deferred exchange
With a deferred or delayed exchange, the seller and buyer exchange their properties at different times. Here comes the IRS “legalese”: However, the purchase of one property and the sale of the other one must be “mutually dependent portions of one integrated transaction.”
What it means is that the rules for this type of a Section 1031 exchange are very complex and you need to have competent and experienced professionals handling it.
A reverse exchange
In this type of exchange, the new property is bought before the old property is sold. Sometimes, you have to use an “exchange accommodation titleholder” who gets to hold the new property for no more than 180 days while the old property is being sold. As you might imagine, there are very complex rules involved, so get an experienced professional.
Look out for 1031 exchange scams
Keep a sharp eye out for scammers promoting a Section 1031 exchange. They will use different tactics, even trying to promote non-qualified property. They’ll advertise that a transaction is totally tax free, when, in fact, it’s only tax deferred. If it sounds too good to be true, it probably is.
Gust Lenglet is the CEO of HBS Financial Group, Ltd., an accounting & tax preparation firm in Maryland. He has more than 25 years of experience in the banking and financial industry. Gust started his career as a loan officer at a major national bank, and then moved on to become controller of a major law firm. In recent years, he has written many financial articles that have been published on Ezine Articles and many websites.