1031 Exchanges: Generally
Tax Free Exchanges of like kind real property used in a trade or business, or for investment, are allowed under the IRC Sec. 1031. Real property generally qualifies as a like kind asset to other real property, even if the difference in value or appearance is significant. This technique allows growing companies to move into bigger buildings and defer tax on any appreciation. It also allows investors to exchange one rental property for another. 1031 Exchanges do not always fit the fact pattern, but when they do, they are a great option.
If you receive “boot” (cash) as part of the exchange, you will be taxed to the extent of your built- in gains on the relinquished property, even if it otherwise qualifies under Sec. 1031. There are other well-established rules and guidelines that taxpayers should heed in order to defer the built-in gains on currently owned business or investment properties.
Timeline and Property Classification
The property must be used in a trade or business, or for investment. If you own a rental property and have decided to upgrade to a different investment property, then you can defer the built-in gain of your current property. You must identify a like-kind property to purchase within 45 days of the first sale and close on the replacement property within 180 days. Generally, you can identify up to three properties. This is helpful if you are unsure of which property you will actually purchase. Failing to properly identify properties within 45 days of the first sale is frequently where taxpayers lose the benefit of using Sec. 1031.
The classification of the property as investment must be able to withstand IRS scrutiny. The IRS has provided a safe harbor for mixed use rentals that allows personal use of the property for up to 14 days in the 12 months before the sale, with a post exchange period of 24 months that ensures the replacement property continues to be an investment property. If you eventually want to retire in the investment property or make it strictly a personal residence/vacation home beyond the 24 months, you can do that.
Use a Middleman
Also referred to as a Qualified Intermediary. This professional ensures the IRS rules are followed so you get the intended results. Using a Qualified Intermediary avoids pitfalls like commingling assets or losing track of certain deadlines. The Replacement Period (the time after the first sale and before the purchase of replacement property) is often a danger zone for taxpayers. A seasoned middleman can help you through this without incident. Frequently, CPAs or lawyers will also serve as Qualified Intermediaries.
1031 Exchanges are a great option for taxpayers who want to upgrade business or investment properties, or simply to relocate. As long as the rules are followed, this (usually) tax-free exchange is available to defer tax and keep more money in your operating account.