For those looking to avoid paying capital gains tax when selling an investment real estate property, doing a 1031 exchange (also called a like-kind exchange or a Starker exchange) allows you to do so by reinvesting your profits into another similar property within a certain period of time. According to Investopedia, the term 1031 exchange comes from Section 1031 of the Internal Revenue Code. It has become so popular in recent years as to be used as a verb by even those outside the fields of finance and real estate, as in, “Let’s 1031 that building for another.”
1031 Exchange Highlights
A 1031 exchange is a tax break. In effect, you can change the form of your investment without (as the IRS sees it) cashing out or recognizing a capital gain. That allows your investment to continue to grow tax-deferred. You can sell a property and swap it for a new one that you purchase for the same purpose, allowing you to defer capital gains tax on the sale. For instance, you can exchange an apartment building for raw land or a ranch for a strip mall, provided they are located in the United States. This doesn’t apply to primary residences but must be used for business or investment purposes.
Proceeds from the sale must be held in escrow by a third party, then used to buy the new property; you cannot receive them, even temporarily. This is the reason it is not taxed, and it’s important! As the seller does not receive the proceeds, it is not considered a taxable event according to the code established by the Internal Revenue Service. Trying to access that money nullifies the benefits of the 1031 Exchange.
The properties being exchanged must be considered like-kind in the eyes of the IRS for capital gains taxes to be deferred. “If, as part of the exchange, you also receive other (not like-kind) property or money, you must recognize a gain to the extent of the other property and money received. You can’t recognize a loss.”
1031 exchanges can be used as frequently as needed, provided it is done correctly. Also, if the replacement property or properties are of the same value, the exchange will have no issue, provided they are all used for business or investment.
Under specific conditions, a former principal residence can be exchanged. Some of these conditions involve converting that residence into a rental property for some time before it can be considered for the swap.
Hiring a professional intermediary is always advisable when undergoing this sort of endeavor. An experienced real estate attorney not only prepares documents but also fields questions and assures a smoother operation in all real estate proceedings. They are an administrator that facilitates the mechanics of a 1031 exchange of real estate-assuring that your exchange complies with the IRS Regulations on the sale of your relinquished property and the purchase of your replacement property, ensuring an accurate paper trail for the exchange.