A 1031 exchange, otherwise known as a tax-free exchange, is a process by which an investor is able to defer paying capital gains taxes when selling an investment property by reinvesting the proceeds of the sale into a “like-kind” property or properties of equal or greater value within certain time limits as defined by Section 1031 of the U.S. Internal Revenue Code. This definition contains a number of operative terms that require elaboration.
“…defer paying capital gains…”
Capital gains are calculated by based on the investment’s adjusted basis, which is the original basis plus any capital improvements minus cost recovery deductions. The value of the cost recovery taken is taxed at a different rate and included in the taxable income from the sale.
“…when selling an investment property by reinvesting the proceeds of the sale…”
One of the requirements for a 1031 exchange is for the sale proceeds to be transferred to a “qualified intermediary,” an independent, third party, which then transfers those proceeds to the seller of the replacement property or properties. The seller of the original property can at no point handle the funds.
“…into a ‘like-kind’…”
This refers to the classification of the asset according to the Internal Revenue Code (IRC), in this case Section 1231, property held for use in trade or business. This means that a residential property can be exchanged for an office property and/or vacant land can be exchanged for an industrial property as long as they are held for investment purposes.
“…property or properties of equal or greater value…”
Sellers are allowed to identify 3 like-kind properties regardless of their market value (three-property rule) or an unlimited number of properties as long as their total market value does not exceed 200% of the property being sold (200% rule). Another less commonly known or used option is the 95% rule, which allows the seller to identify more than 3 properties with a total value that is greater than 200% of the property being exchanged IF they acquire at least 95% of the value of the properties identified.
“…within certain time limits…”
The timeline under a 1031 exchange are measured from the sale of the property being exchanged. Sellers have 45 days to identify/nominate (in writing) the prospective replacement property or properties and 180 days to acquire/close on the same (not 45 days plus 180 days).
“…as defined by Section 1031 of the U.S. Internal Revenue Code…”
The IRS strictly enforces the rules and regulations governing 1031 exchanges and due to their complexity it is advised that investors seek the guidance and assistance of licensed professionals when handling such transactions.