In Benjamin Franklin’s infamous words, the only things in life that are certain are death and taxes. Unfortunately for Franklin, he wasn’t alive before the section 1031 tax code was implemented.
While most people avoid tax jargon like the plague, the 1031 exchange is quickly becoming a part of everyday vocabulary. The 1031 exchange is also known as a like-kind exchange or a Starker exchange. It’s gain in popularity is due to its ability to allow asset holders to swap investment properties with limited or no taxes due at the time of exchange.
Keep reading to learn more about what exactly makes up a 1031 exchange, how it can help investors, and what restrictions are involved.
What Exactly is a 1031 Exchange?
Originally the 1031 section of the tax code involved the ability to make like-kind exchanges on a variety of personal property including artwork, heavy machinery and equipment, and franchises. In December of 2017, the tax code shifted so that now 1031 exchanges are limited to real estate properties and are not intended for personal use.
The IRC Section 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
Essentially section 1031 gives investors the ability to defer capital gains taxes on like-kind properties only for the purpose of business or investments. What does this mean exactly? When a real estate investor goes to sell an asset, they would normally be taxed on the profit they receive from the sale. But, if they turn around and use that money to purchase another piece of property, the tax is deferred.
Why is a 1031 Exchange Important?
1031 exchanges are extremely important for real estate investors looking to make their investments go further. When selling and buying properties that qualify for 1031 exchanges, real estate investors are able to put off paying taxes on their capital gains and essentially compound their gains tax-free for a period of time.
While real estate investors will eventually have to pay taxes on their properties when they sell them, investors can use the money they’ve saved by deferring taxes to invest in bigger and better properties that will give them a bigger payout later down the road.
What Properties Qualify?
In order for a property to qualify for a 1031 exchange according to the IRS, they must follow the rules for a like-kind exchange. Here is the IRS’s official stance on what kinds of properties qualify:
“Both properties must be similar enough to qualify as ‘like-kind.’ Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.”
Determining what a like-kind property is can be tricky. Contrary to what it may seem, like-kind properties do not have to be identical to each other. In fact, when it comes to like-kind properties the rules are flexible. For example a rental home can easily be exchanged for a strip mall, or an apartment building can be exchanged for a plot of farm land. You should always check with a professional (insert link to company website) in order to determine if your investment property qualifies for a 1031 exchange.
Are There Any Restrictions?
If your property is in fact a like-kind property with the one you are planning to buy, there are still a few other factors to take into consideration before ensuring that your investment is 1031 exchange ready.
Below are a few common restrictions that you should be aware of when looking into a 1031 exchange.
If you plan on delaying your 1031 exchange as mentioned in the considerations above, it’s important to keep in mind the IRS enforces strict timing when doing so.
According to the official IRS tax 1031 exchange tax code: The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange. Notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.
In addition to this 45 day time limit, there is a second time restriction whereby the “property must be received and the exchange completed no later than 180 days after the sale of the exchanged property.”
There are many benefits when it comes to using a 1031 exchange in your real estate investments. It’s important that as an investor you become familiar with the restrictions and rules that go along with 1031 exchanges. When done the right way, real estate investors can use the 1031 exchange to their advantage and further their wealth in the long run.