1031 Real Estate Investment Property Exchange Basics

A 1031 property exchange is authorized by Section 1031 of the Internal Revenue Service tax code and allows investors to buy and sell like kind property while deferring capital gains tax. 1031 investors are able to reinvest 100 percent of the equity from the sale of property into the purchase of a 1031 replacement property without recognizing any gain on their tax return.

 

A 1031 property exchange is also referred to as a 1031 tax deferred exchange. A deferred exchange is a exchange in which you transfer qualified property called "Relinquished Property" and receive qualified property called "Replacement Property" in exchange.

 

Qualifying property is property or equipment which is held for investment purposes or used in the taxpayer's trade or business. Investment property includes improved or unimproved real estate held for investment or income producing purposes. Investment property used in the taxpayer's trade or business includes the building where s/he is doing business, as well as equipment used in his or her trade or business. Real estate must be replaced with like-kind real estate. Equipment must be replaced with like-kind equipment.

 

Most deferred exchanges are facilitated by Qualified Intermediaries, who assist the taxpayer in meeting the requirements of Section 1031. Qualified Intermediaries are a separate legal entity, which serve as your agent and do all the exchange stuff for you.

 

There are two time requirements that must be strictly adhered to in 1031 Exchanges. The first time limitation requires a "Replacement Property" to be identified within 45 calendar days of the transfer of the "Relinquished Property". This is called the "Identification Period".

 

The second time limitation is called the "Exchange Period". The exchange period begins on the date the "Relinquished Property" is transferred and ends 180 calendar days thereafter. The exchange must be completed during the 180-day Exchange Period.

 

Another thing to be aware of is that you cannot receive any cash from the sale of your Relinquished Property. If you sell the property, the proceeds must go to a Qualified Intermediary. The QI will reinvest the gains into the Replacement Property, therefore no cash transaction will ever occur in a 1031 property exchange.

 

Additionally, you can only exchange property held for investment or for business use. You cannot use a 1031 property exchange to exchange your personal home or vacation home, unless you rent it out. You also cannot exchange inventory, a partnership interest or stocks and bonds.

Capital gains taxes are deferred if all of the exchange funds are used to purchase like-kind investment property. The deferment is like getting an interest-free loan on the tax dollars you would have owed for a cash sale.