1031 exchange

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A 1031 exchange, also known as a like kind exchange, is a transaction under United States law which specifies that if an asset (usually some form of real estate such as land or a building) is sold and the proceeds of the sale are then reinvested in a like kind asset, then no gain or loss is recognized, allowing the deferment of capital gains taxes that would otherwise have been due on the first sale. This law is defined by section 1031 of the Internal Revenue Code, 26 U.S.C. § 1031.

In order to qualify for this exchange, certain rules must be followed.:

1. Both the relinquished property and the replacement property must be held either for investment or for productive use in a trade or business. A personal residence cannot be exchanged.
2. The asset must be of like kind. Real property must be exchanged for real property. Personal property must be exchanged for personal property. (There are some complicated rules surrounding this -- for example, livestock of opposite sex are not considered like kind property for the purpose of a 1031 exchange.)
3. The proceeds of the sale must be invested in a like kind asset within 180 days of the sale. However, the property must be identified within 45 days.

Frequently, the most difficult component of a 1031 exchange is identifying a replacement property within the first 45 days following the sale of the relinquished property. The IRS is strict in not allowing extensions.

A 1031 exchange is similar to a traditional IRA or 401K retirement plan. When someone sells assets in tax-deferred retirement plans, the capital gains that would otherwise be taxable are deferred until they begin to cash out of the retirement plan. The same principal holds true for tax-deferred exchanges or real estate investments. As long as the money continues to be re-invested in other real estate, the capital gains taxes can be deffered. Unlike the aforementioned retirement accounts, rental income on real estate investments will continue to be taxed as net income is realized.

An alternative to a 1031 exchange for someone who wants to defer capital gains tax but does not want to continue to hold property is a structured sale.

Example of a 1031 exchange

An investor buys a strip mall (a commercial property) for $200,000. After six years he sells the property for $250,000. This results in a gain of $50,000 on which the investor would have to pay a capital gains tax. But if he invests the $250,000 in another property, then he does not have to pay any taxes on the gain now.

How a 1031 exchange is accomplished

The following sequence represents the order of steps in a typical 1031 exchange.

1. An investor decides to sell investment property and do a 1031 exchange. He contacts a qualified intermediary (QI).
2. The investment property is put on the market.
3. An offer to purchase the investment property is accepted.
4. Escrow for the sale is opened, and a preliminary title report is produced.
5. The QI sends required exchange documents to the escrow closer for signing at property closing.
6. Escrow closes.
7. Within the first 45 days after the close of escrow on the sale of the relinquished property, the investor identifies replacement property as required by law. This is known as the "Identification Period".
8. Within 180 days after the close of escrow on the sale of the relinquished property, the investor closes on the replacement property that he identified. This is called the "Exchange Period". This completes the exchange.

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