Under Section 1031 of the United States Internal Revenue Code, 1038 exchangeallows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC Section 1031 (a)(1) states that no gain or loss shall be recognised on the exchanging of real property held for productive use in trade, business or for investment, if such property is exchanged solely for real property of a like kind which is to be held either for productive uses in a trade or business or for investment.
1031 is gradually making its way into our daily conversations but there isn’t a lot known about the provision. But here’s something you should always remember for information sake; At the time of the sale, 1031 property exchanges are not taxed, that is because you are exchanging property not selling it. An other important thing to know about it is that “1031” is not restricted to real estate.
That being said, here are some things you should know about a 1031:
“LIKE-KIND” REFERS TO A BROAD SPECTRUM
The “..if such property is exchanged solely for real property of a like-kind which..” doesn’t necessarily mean what you perceive. The “like-kind” term is pretty flexible, essentially meaning that you don’t really have to swap a condominium for an apartment complex. You could exchange your apartment for raw land! That’s right, the rules are quite liberal.
1031 IS NOT FOR PERSON USE
Though there are a few exceptions, generally 1038 is not for personal use. The 1038 Real Estate Exchange is only for investment and business property. Unless your primary property is now rental property, a 1038 cannot be applied. You can’t swap your primary property for another house.
The delayed exchange is pretty straightforward: the Exchanger swaps property before he acquires property. To put it simply, you owning the exact type property another person wants and him owning the exact kind is pretty unrealistic. Thusly exchanges are often delayed. So, once one of the exchangers sells the property, the money is kept with the middleman who then buys the replacement property for you. This third party exchange agreement is known as “delayed exchange.”Remember, that the third party must be a qualified intermediary or else the exchange is not possible.
MORTAGES AND DEBTS MUST BE CONSIDERED
Remember that the property that you relinquish may come with mortgages and debts. If you do not get cash back for the relinquished property but your liability goes down, then that too would be considered capital but it will be taxed of course.
PURCHASES WORTH LESS THAN THE ORIGINAL PROPERTY
A 1031 exchange allows the investor to sell a real estate property and then reinvest the capital in a property of equal or greater value. The investor cannot make a purchase for less than the original property, (The like-kind rule). This would defeat the purpose of deferring taxes on again.
BOTH PROPERTIES MUST BE HELD FOR PRODUCTIVE PURPOSES
Both the relinquished property and the replacement property must only be used for the purpose of investment, trade or business. Rental property which is no longer considered as primary property, should be rented for a minimum of two weeks.
You can hold the property for as long as you want, 1031 property exchanges are not taxed. That’s right for as long as you may hold the property, you defer taxes!
That’s all for today folks! 1031 Exchange can be tricky and a bit complicated to get a hang of at first but it’s not rocket science. A little more of reading and researching and you’ll get the hang of it in no time!