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What is 1031 Tax Exchange?

A 1031 tax exchange is a powerful method for deferring the tax consequences of the sale of investment property. If you own rental properties, in particular, a 1031 tax exchange should be part of your tax strategy.

When a 1031 tax exchange is mentioned, it refers to the 1031 section of the tax code and the deferment of capital gains taxes. Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized. Put another way, it is best to exchange the property for similar property.

Properties are of like-kind if they are of the same nature or character, even if they differ in grade or quality. Real property generally is of like-kind, regardless of whether the properties are improved or unimproved. The 1031 tax exchange, however, only works with investment property, not your personal residence. You can use the revenues from one property to buy multiple properties or vice versa, but you can’t use the revenues from the sale of rental duplexes to buy a ranch. It is so technical as to be beyond the scope of a simple one page article. You should always use a tax professional to assist you in the exchange.

Unlike traditional real estate transactions, a 1031 tax exchange requires the use of a third party known as a qualified intermediary. This person acts somewhat like an escrow company, but only to the extent of handling the monetary transactions. When you sell property, the proceeds are transferred directly to the qualified intermediary who then uses them to make the new purchase. Any unused funds are subject to capital gains taxes.

As you might imagine, 1031 tax exchanges have strict time limits. From the date of sale of your property, you have 45 days to find new properties and provide written notice to the qualified intermediary. The IRS is a bear when it comes to this rule, so you must have your ducks in order. Once you’ve identified the properties, you have 180 days to close from the date of your original sale. Again, the IRS doesn’t budge an inch on this deadline.

A 1031 tax exchange is a great way to defer taxes. By using it, you essentially get to use tax payments to continue to fund your wealth building activities. That being said, you must be very organized because the time limits are strictly enforced by the IRS. The use of a tax professional and real estate attorney are highly advisable.