Business & Finance Taxes

1031 Tax Deferred Exchange Rules

By Business & Finance Last updated Sunday, April/07/2024

The 1031 exchange is an excellent tool to reduce capital gains taxnice real estate image by Denise Kappa from Fotolia.com

A sale of a business or investment property normally requires that the seller pay capital gains tax on the increase in value at the time of sale. An exception to this is described under the rules of the Internal Revenue Code (IRC) in section 1031. The so-called 1031 exchange allows the proceeds of the sale to be reinvested into a similar, qualifying property, and for the capital gains tax to be postponed. Use of the 1031 exchange has the effect of allowing an investment property owner to roll up into larger properties without paying a financial penalty.

Owner Qualifications

First you should determine if you qualify to complete a 1031 exchange. Most people or business entities do. The IRC says that individuals, C corporations, S corporations, partnerships, limited liability companies, trusts, and any other tax paying entity is qualified to set up a swap of business or investment properties under section 1031.

According to the rules of section 1031, there are three general methods in which the swap can take place. The first, and simplest, involves a simultaneous exchange of one property for another. A deferred exchange allows more flexibility by allowing the sale of one property and purchase of the new one within a certain time frame. A reverse exchange is the most complex of the 1031 methods. This is when the replacement property is acquired first and title parked at an exchange accommodation titleholder, which is allowed to hold the title for 180 days while the owner completes the sale of the original property. One must be careful to heed the IRC time guidelines. If your transaction ends up falling outside the parameters, the capital gains tax will come due.

Both properties involved in a 1031 exchange are particularly described by the IRC. Each must be used in a trade or business or as an investment. This rule is used to prevent home owners from using a 1031 exchange in regard to their primary residence or vacation home. While the IRC defines that both properties must be like kind in character, nature, and class, the reality of the rule is that almost all real estate falls into the same class. For example, an investor could sell an undeveloped property and roll the proceeds into purchase of property with a house on it and the transaction still be considered like-kind.

The last major area of rules in a 1031 exchange are the time limits. As mentioned already, these are strict limits set by the Internal Revenue Service. The seller of the original property has 45 days from the sale to identify potential replacement properties. This identification must be made in writing to a qualified intermediary. The second limit is that the replacement property purchase must be completed within 180 days of the sale of the original property, or the due date of the tax return for the tax year in which the first property was sold, whichever comes first.