What is a 1031 Exchange?
A 1031 Exchange, as defined in Section 1031 of the Internal Revenue Code, is a transaction in which a taxpayer is allowed to sell a property and exchange it for a like property without having to pay any capital gains tax arising from the sale of the property. However, Section 1031 Exchanges do not apply to the exchange of real property in the United States and real property outside the United States.
The investor is able to use 100% of the proceeds from the sale of the investor's property to purchase a new property and defer capital gains taxes until such time as the exchange property is sold. This can be accomplished through a simultaneous or delayed 1031 Exchange. This is one of the best investment strategies available to investors.
If during the exchange, an investor receives other non-like property (commonly referred to as "boot"), then the investor's gain is recognized on the boot, and the investor must pay tax on it. However note that loss is not recognized on the non-like property. 1031 Exchanges give real estate investors not only greater leverage, diversification and improved cash flow, but also geographic relocation and/or property consolidation.
What are the IRS Section 1031 Requirements for a Valid 1031 Exchange?
The IRS requirements for a valid 1031 Exchange are as follows:
- Qualified Use
- Proper purpose.
- Like-kind property.
- Exchange requirements.
How Do 1031 Exchanges Work?
1031 Exchanges normally involve a four-step process:
- The seller sells their property and includes exchange language in contract. Something to the effect that the buyer and seller agree to participate in a 1031 Exchange at no additional costs to the buyer.
- A Qualified Intermediary pursuant to Section 1031 of the Internal Revenue Code is selected. The Qualified Intermediary will send all the paperwork to the escrow company prior to closing. The proceeds at the closing of the sale will go to the Intermediary.
- The seller must identify a potential exchange property within 45 days of the closing. As many as three properties may be identified.
- The seller must complete the 1031 Exchange within 180 days of closing of the sale of the property.
These steps can occur simultaneously. It is best to consider what type of replacement property you require prior to selling your property and whether you want to own it entirely or just a partial interest.
When do I need to identify my Exchange Property and How Long Do I have to Purchase Replacement Property?
The IRS rules require that you must identify the exchange property in writing within 45 days from the close of the relinquished property sale and complete the purchase of the like-kind exchange property within 180 days to qualify for the tax deferment. Once you have closed on the like-kind exchange property, any proceeds from your relinquished sale will be returned to you.
What is a Reverse Exchange?
A reverse exchange is where the replacement property is acquired prior to the relinquished property being sold. The IRS has established safe harbor rules regarding reverse exchanges. You should consult your attorney or tax adviser for more information.
What are the Reasons for doing a Reverse Exchange?
Reverse exchanges are typically used more in depressed real estate markets. The most common reason to do a reverse exchange is when you secure a great deal on a property, you have your financing available and you have not been able to sell your property prior to purchasing your replacement property.
What is the Difference between a 1031 Exchange and a Reverse Exchange?
The reverse exchange rules require the entire reverse exchange to be completed within 180 days of the date your Qualified Intermediary acquires the replacement property for you.
Why is Triple-Net (NNN) Leased Real Estate Suitable for 1031 Exchanges?
Investors seeking suitable replacement property for their 1031 Exchange look to NNN properties for the following reasons: the structure may provide relief of management obligations, such as multi-family apartment complex owners that are looking for relief but still need the income, want to defer their tax responsibilities, and no longer want intensive landlord responsibilities. Investors may also consider NNN properties for assured income, pride of individual ownership and preservation of capital. NNN leases may also interest investors that want to provide a relatively easy estate asset for their heirs.
What Role Does ROI Commercial Property Brokerage (RCPB) Play in a Section 1031 Exchange?
NLCA is a Licensed Real Estate Broker. Our role is to assist buyers in finding suitable replacement property for their exchange. We focus our efforts primarily on Net Lease commercial properties.
For more information on 1031 Exchanges, please refer to the Internal Revenue Code website
, or contact your attorney or tax adviser.