If you’re a real estate investor and frequently buy and sell real estate, you must know about §1031 exchanges. A transaction structured as a §1031 exchange can defer taxable gains on certain real estate sales. Our experienced Kentucky real estate attorneys explain why this works to your advantage.
What Does a §1031 Exchange Allow?
Sometimes referred to as a like-kind exchange, a §1031 exchange allows a person to sell one property and invest the proceeds from the sale into the purchase of another property—without paying capital gains taxes normally due on the sale of the first property.
The capital gains taxes expected from the sale of the first property are deferred until the sale of the replacement property. Things really get interesting when the sale of the second property is also used for a §1031 exchange into the purchase of a third property, and then a fourth property, and so on, deferring capital gains tax for years.
Generally speaking, any real property can be exchanged—provided it’s held for productive use in a trade or business or for investment. Then, it can be exchanged for property of like kind that will also be held for one of these same purposes.
Setting Up a §1031 Exchange
A transaction must be structured as a §1031 exchange, rather than a normal sale and purchase. An entity known as a qualified intermediary must be involved with the sale of the first property and the purchase of the replacement property. The seller of the first property normally signs an exchange agreement assigning the purchase contract on the first property to the qualified intermediary.
At closing, the proceeds from the sale aren’t sent to the seller but to the qualified intermediary, who holds the proceeds until the replacement property is identified. Once this happens, the closing is set, and the qualified intermediary releases the proceeds to be used for the purchase of the replacement property. So long as all the steps are followed, no capital gains tax is due on the proceeds from the sale of the first property.
There are some restrictions involved in §1031 exchanges:
- Properties involved must generally be used in business or held for investment.
- Exchanges aren’t used for private residences or vacation homes.
- The second property must also be like-kind to the property relinquished. The rules are quite broad on what is considered to be like-kind, so you’ll want to work closely with your real estate attorney to make sure the replacement property qualifies.
- There’s a same taxpayer rule, which holds that the same taxpayer must relinquish the first property and purchase the replacement property.
Finally, to defer all capital gains taxes, the replacement property must be equal or greater in value, equity, and debt than the relinquished property. However, there are also exceptions to these rules.
Timeframe to Establish a §1031 Exchange
To take advantage of this opportunity, there are key timelines to follow. From the sale of the original property, you have 45 days to locate and identify the next purchase. In addition to following that timeline, investors have 180 days from the closing on the first property to close on the next property.
Partnering with an experienced attorney on these types of transactions ensures they qualify as like-kind exchanges under §1031 of the Internal Revenue Code, and follow all stipulations of the law. You also have the added benefit of someone who can extend valuable assistance in adhering to the timelines and advise on other real estate strategies, such as when to include a Deleware statutory trust in your plan.