A 1031 or tax deferred exchange allows a property owner to sell one property and then go straight into buying another one in a certain time period. The name comes from the fact that the transaction is an exchange and not just a straightforward sale. In this process, the tax payer is eligible for a deferred gain, as property sales are taxed by the IRS but 1031 exchanges aren’t. A 1031 exchange is recognized by the IRS as a means to defer capital gains taxes, so it is vital you understand what is involved, what the rules are and what the underlying intent is before you can think about performing one.
Any property owners who will acquire a replacement “like kind” piece of real estate should think about a 1031 exchange before the existing property has been sold. A property sale would incur a 15 per cent capital gains tax at the current rates, but this could go up to as much as 30 per cent once federal and state taxes have been incorporated. By doing a 1031 exchange, you can circumnavigate this until such time as your property is sold for cash.
Capital real estate investment is depreciated at 3 per cent per annum on condition that you hold the investment until it has depreciated fully. On selling the property, the IRS will tax you on the portion that has depreciated as income tax.
There are two baseline rules that need to be followed, in conjunction with other stipulations set forth by the IRS, for a 1031 exchange. The first rule is that the replacement “like kind” real estate’s total price must be the same as, or greater than, the total net sale total of the property that was relinquished. The second rule is that all of the equity that was acquired as a result of the sale of the property that was relinquished needs to be used in acquiring the new “like kind” property. If the value of the acquired property decreases, tax will apply to the difference.
Not following either of these rules will result in tax liability for the person performing the 1031 exchange. When the replacement property is lower in value than the acquired property, the person will incur a tax responsibility. Also, if all the equity is not transferred the “like kind” property taxation rules will also apply. Partial exchanges can also be performed, and these are usually also eligible for a partial deferral of tax.
Only a Qualified Intermediary (QI) may handle the proceeds of the sale of the original property, otherwise all proceeds will be considered taxable. The entire amount acquired in the sale needs to be invested in the new property acquisition, and if any cash is retained from the proceeds it will be taxable. It is also important to note that this does not only apply to cash. Even if you do not physically receive the cash, but your liability on the acquired property decreases, you will still be taxed.