Section 1031 Exchanges

My real estate clients often come to me for help with 1031 exchanges. However, many clients are not aware that 1031 exchanges are not limited to real estate transactions, as businesses which are considered like-kind can also qualify for 1031 exchange treatment. In addition, real property can also be subject to 1031 exchange treatment, provided that certain restrictions are met.

A 1031 exchange is a swap of one real estate investment property or business for another that allows capital gains taxes to be deferred. The term gets its name from Section 1031 of the Internal Revenue Code.

Broadly stated, a 1031 exchange (also called a like-kind exchange) is a swap of one investment property for another. Most swaps are taxable as sales, although if yours meets the requirements of 1031, you’ll either have no tax or limited tax due at the time of the exchange.

In effect, you can change the form of your investment without cashing out or recognizing a capital gain. This allows your investment to continue to grow tax-deferred. There’s no limit on how frequently you can do a 1031 exchange. You can roll over the gain from one piece of investment property to another for as long as you are able to meet the 1031 exchange requirements. As a result, you avoid paying tax on each property exchange until you sell your property without a subsequent exchange. On the final sale, you’ll only pay tax once at long-term capital gains rates.

Who qualifies for a Section 1031 exchange?

Owners of investment property may qualify for 1031 exchange treatment. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may engage in a 1031 exchange.

What property qualifies for a Section 1031 Exchange?

Both the relinquished property you sell and the replacement property you buy must meet certain requirements. Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment. Both properties must be similar enough to qualify as "like-kind."

Like-kind property is property of the same nature, character or class. 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. Real property and personal property can both qualify as exchange properties under Section 1031; but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks.

What are the time limits to complete a Section 1031 Exchange?

While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable. 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 like the seller of the replacement property or the qualified intermediary. Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name.

The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above.

Conclusion

As the rules for 1031 exchanges can be complex, it is important that you speak with a tax advisor when entering into a 1031 exchange. This is because the time limits and restrictions on 1031 exchanges vary based upon the property being exchanged, so an analysis needs to be performed regarding the 1031 exchange rules which apply to your particular exchange. In this way, you can ensure that your 1031 exchange was done properly and be prepared in the event of audit.