1031 Exchange and What it Means For Real Estate Investing
What is Section 1031?
Whenever you have a gain on the sale of a real estate investment property, you generally have to pay tax on the gain at the time of the sale. However, IRC Section 1031 provides an exemption and allows you to postpone paying tax on the gain if you reinvest the proceeds in a similar property.
Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corps, S corps, partnerships, LLCs, trusts, and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031.
Types of Properties That Qualify
Well, that depends on the discretion of the IRS. The IRS states the properties must be “like-kind”. If this seems a bit vague to you, you’re not alone. The IRS defines “like-kind” as:
“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.”
Most would assume this means exchanging one very similar piece of property, say, a ranch house in an up and coming Detroit neighborhood, for another ranch house in a similar neighborhood, with similar values. This isn’t the case. The rules are surprisingly liberal. You could potentially exchange a condo for a strip mall, or a colonial for raw land.
1031 Exchange Conditions
Now that we’ve navigated the vague waters of “like-kind”, there are several restrictions on 1031 Exchanges.
If the property you’re exchanging for is less expensive than the property you will exchange, you will face tax considerations for the price difference. You must also own the property being exchanged, owning a share in a real estate investment trust, a fund, or an LLC that owns a share in another LLC disqualifies you from utilizing a 1031 Exchange. There are also two timing restrictions to consider.
The first limit is that you must provide, in writing, signed by you, delivered to a person involved in the exchange like the seller of the replacement property, and within 45 days of the sale of the relinquished property, is identification of potential replacement properties. Replacement properties must be clearly described in written identification, this means providing a legal description, street address, or distinguishable name.
The second limit that must be met is within 180 days after the sale of the exchanged property, the replacement property must be received and the exchange completed. The replacement property must be considerably similar to the property identified within the 45-day limit. There is more clarity at this stage than when previously dealing with “like-kind”. If at the 45-day limit you provide a written description of a two bedroom ranch and then purchase an apartment complex, you will more than likely be stuck with the taxes.