1031 Exchange Information Guide 101
A smart tax saving tool that is gaining popularity among real estate investors by allowing them to defer all capital gains tax is 1031 Exchange. Established in 1990 by Section 1.1031 of the Internal Revenue Code, it gives you the opportunity to defer your capital gains taxes on the sale of a property by reinvesting the proceeds in “a like type” of property. However, it is necessary to have a complete understanding of the terms and conditions that apply to 1031 Exchange and how it works.
Some very basic things one should understand about the 1031 Exchange are that only commercial and investment properties qualify for tax deferral under Section 1031. Also, the properties involved in the transactions must be of a “like type.” The term “similar” has often been misinterpreted to mean that if someone is selling a 1,200-square-foot office, they should invest the money they make from the sale to buy a 1,200-square-foot office only. However, this is not the case and this term has a very broad meaning. Actually, it encompasses any real property held for productive use in a business or for investment. For personal property to qualify, it must be depreciable and form part of the daily operations of a trade or business, for example, automobiles, office equipment and furniture, machinery, computers, billboards, franchise licenses, and the like. 1031 Exchange does not cover cash, stocks in trade, or other property held primarily for sale, such as stocks, bonds, promissory notes, or other securities or evidence of indebtedness, partnership interest, and certificates of trust or beneficial interest.
Real estate to which the 1031 Exchange rules apply includes raw land, single-family homes, hotels, multi-family homes, factory and office buildings, shopping centers, farmland, etc. Also, all income earned from the sale of a property must be transferred through a qualified intermediary and not by someone who is the beneficiary, so that no one can use this money for their own financial gain. To defer capital gains tax, the earnings must be reinvested in a similar type of property, which must be of equal or greater value and equity than the property exchanged. In addition, the time allowed for reinvestment must be respected. After selling the property to be exchanged, a replacement property must be identified within 45 days and the exchange must be completed within 180 days.
Deferring all capital gains taxes is not the only benefit to come from the 1031 exchange. It also has some hidden benefits, such as the provision to reinvest in other property can significantly increase one’s assets. Also, as real estate assets increase in value, one can easily upgrade to a higher value property with the additional cash flow. 1031 Exchange also provides the flexibility to exchange rental properties that have appreciated in hot markets and reinvest in lesser-known areas that are expected to increase in value and become the next hot markets in the coming years.