Whenever you sell off a piece of investment property for a gain, you generally pay tax on that gain at the time of the sale. If you then use the post-tax proceeds to purchase another property that you later sell for a gain, you’ve effectively traded one property for another, but you were taxed twice along the way. Luckily, the tax code contains Section 1031, which allows for a tax deferred “exchange” of properties, and it can be a lifesaver for investors.
The basic gist of Section 1031 is that when you sell a piece of investment property, you defer payment of capital gains tax by acquiring a replacement property. That sounds simple enough, but the transaction must follow a very specific set of rules along a very tight timeline to qualify for the deferred tax treatment. To be fair, this transaction ultimately would save the investor a sizeable chunk of gain, so jumping through the necessary hoops is a relatively small price to pay. Let’s dig into the general requirements and the timeline for this complex transaction.
1. Qualified intermediary
Each Section 1031 transaction requires the use of a Qualified Intermediary, sometimes referred to as either a 1031 Exchange Accommodator or 1031 Exchange Facilitator, who must be assigned into the Purchase and Sale Agreement or Contract and any Escrow Instructions before the close of the transactions. The transaction does not qualify otherwise. The Qualified Intermediary ensures that the transaction is properly structured and must essentially step into your shoes as buyer or seller of the particular property to make the transaction valid.
2. Replacement Property
The property you choose as replacement property must be of a very specific type. First, it must be equal or greater in net purchase value than the net sale value of the property being sold. All of the net proceeds from the sale of Property 1 must be invested in Property 2. The same goes for debt – paid-off debt from Property 1 must be replaced with an equal amount of debt on Property 2. You can certainly put more cash into Property 2, but any cash you pull from the sale of Property 1 is subject to depreciation capture or capital gains tax liability. It’s important to note, however, that a Section 1031 exchange is not necessarily a 1-for-1 swap. Multiple properties can be sold for the purchase of a single property, and vice versa. There are many ways to structure these exchanges and nuances that go along with them.
Second, the property must have a qualifying use, which means it must be held as an investment or rental property, or it must have been used in the course of the owner’s trade or business. It can’t merely be inventory for sale. It isn’t necessary that the property be the exact same kind of property or type of use, so long as it meets the qualifying use requirement.
3. The Transaction
The transaction can take several forms, but all of them follow a basic set of rules. First, the investor has 45 days from the close of Property 1 to identify potential replacement property, and 135 calendar days to complete the exchange. The most common rule used in these exchanges is the “three property identification rule,” where the investor may identify up to three potential like-kind replacement properties. Identifying three properties gives the investor alternatives in the event the preferred replacement property transaction hits a snag. There are further, more complex rules for those who wish to identify more than three properties.
Section 1031 transactions provide a much-needed break from taxation when essentially swapping one investment for another, and there is even more flexibility possible than has been touched on here. If a Section 1031 exchange sounds like a way to keep your money in your pocket, contact the attorneys at McBrayer today.