Section 1031 of the Internal Revenue Code allows a tax-deferred exchange of an investment property for another, as long as the transaction represents a “trade-up” in value. For instance, the exchange for vacant land (which is not yet producing income) for a commercial building that is bringing in rent would be considered eligible for exchange under Section 1031.
Benefits Of A 1031 Exchange
Investors can take advantage of the 1031 tax-deferred exchange to acquire a more valuable investment property. By utilizing the money otherwise paid to the IRS in taxes, investors can increase their overall buying power to acquire a more expensive and profitable replacement property.
With the flexibility of an exchange, an investor may exchange one property for several others, consolidate multiple properties into one, and acquire property in other areas.
INCREASED CASH FLOW/INCOME
Cash flow and overall income can be increased through a 1031 tax-deferred exchange. For example, a vacant parcel of land that generates no cash flow or depreciation benefits can be exchanged for a commercial building that does.
Main Types Of 1031 Exchanges
TRADITIONAL 1031 EXCHANGES
There are two types of traditional 1031 exchanges:
- A delayed exchange is when the relinquished property is sold to a buyer and the replacement property is purchased within 180 days from a third party.
- A simultaneous exchange is when two parties either “swap” properties with each other, or the exchanger closes on both the sale of the relinquished property and the purchase of the replacement property on the same day.
REVERSE EXCHANGES: BUY NOW, SELL LATER
A reverse exchange allows the acquisition of new property before the selling of the existing investment. If a seller cannot sell the existing property within the timeframe to perform a standard 1031 exchange, a qualified intermediary (QI) can hold title on the desired property until the first property sells. The seller is then able to take possession of the new investment parcel from the QI.
Requirements For An Eligible 1031 Exchange
NET SELLING PRICE (NSP)
To avoid capital gains tax on the sale of your relinquished property, you must spend an amount equal or greater than your net selling price (NSP = selling price minus closing cost.)
All real estate can be exchanged as long as it is held for investment or for productive use in a trade or business.
USE OF QUALIFIED INTERMEDIARY (QI)
The regulations require that you use a QI to facilitate your exchange. The QI is the independent third party required by the IRS to act as the middleman in both the sale and purchase transactions. The QI cannot be the taxpayer, a descendant of the taxpayer, or an agent of the taxpayer (realtor, attorney, accountant, etc.). The role of the QI is to prepare the exchange documents, coordinate with the closing agents for each transaction, and escrow the funds. (Click here for a list of top-rated QI’s in the San Francisco Bay Area).
You have 45 calendar days from closing on the sale of the relinquished property to identify up to three replacement properties. If a property has not been properly identified by midnight of the 45th day, you will be unable to complete the exchange. If you wish to identify more than three replacement properties, restrictions will apply.
You must close on the replacement property by the earliest of either the due date of the tax return (including extensions) for the tax year that the exchange took place, or within 180 calendar days after closing on the relinquished property.