Section 1031 of the Internal Revenue Code (IRC) allows real estate investors to defer capital gains taxes by exchanging one property for another “like-kind” property. Of course, as with most IRC provisions, there are specific qualifying criteria as well as time limits associated with a 1031 exchange.
Following is an overview of the 1031 exchange process and what you need to know before you attempt an exchange.
Properties that qualify for a 1031 exchange
A 1031 exchange is an IRC provision that allows real estate investors to exchange an investment or business property for another property of equal or greater value and defer paying capital gains taxes on the profits of the sale. To qualify, a property must meet the following criteria:
- Used for investment or business purposes – A property must be held as an investment or be used for a trade or business. Personal residential property, such as a primary or secondary residence, does not qualify.
- Held within the United States – Foreign-held property does not qualify.
- Like-kind – To qualify for exchange, both the current and the replacement property must be of the same nature, character or class. The IRS’s definition of “like-kind” is broad and allows for a wide range of interpretation. For example, a commercial building could be exchanged for vacant land or a residential property could be exchanged for an industrial building.
- Equal or greater value – The replacement property must be of equal or greater value than the exchanged property to fully defer tax liability.
- Sale proceeds must be reinvested – It is important that all proceeds from a 1031 sale be held in escrow by a qualified intermediary. If you take direct possession of the assets at any point in the process, they become taxable.
Considerations
It is important to be aware of the time requirements and potential tax implications of 1031 exchanges, such as:
- The 45-day rule – Following the sale of your existing property, you have 45 days to identify a replacement property. You must provide a written letter that includes details about the intended replacement property, including a legal description of the property. The letter must be signed by you and the property’s seller or a qualified intermediary.
- The 180-day rule – The IRS requires that you close on the replacement property within 180 days of selling your relinquished property or within 180 days following the date your tax return is due, whichever is sooner. This is a strict deadline. If you fail to close on a new property within 180 days, you will be subject to capital gains tax on the profit from the sale.
- Taxes on the “boot” – Cash that is left over after the partial sale of a relinquished property is referred to as the “boot.” If you, as the investor, take possession of the boot, it may be considered a taxable capital gain.
- Deferred capital gains tax – If you engage in multiple 1031 exchanges throughout the years, you may have a significant amount of deferred capital gains taxes, which can increase your long-term tax exposure. The deferred tax may be eliminated when the assets pass to your heirs and they receive a step-up in cost basis.
How United Capital can help
Completing a 1031 exchange is a complex process with many moving parts. At United Capital, we can help you successfully execute your exchange, avoid tax liabilities and ensure your transaction is in line with your overall financial plan and future goals. As your advisor, we:
- Help you understand the pros and cons of a potential exchange and whether the transaction makes sense for you.
- Evaluate your various options and recommend a 1031 exchange strategy that meets your objectives.
- Help you identify and acquire a replacement property.
- Help ensure your transaction is completed in the most-tax efficient manner possible and in accordance with all IRS rules and timing requirements.
- Consider how the transaction impacts other aspects of your financial life in order to help ensure it is in line with your financial plan and overall financial objectives.
If you would like some help with your 1031 exchange, we would love to have a conversation. To learn more about how United Capital Financial Advisors can help support your financial future, please contact us.
