What is a 1031 Exchange?

Property is often bought and sold for business purposes. It makes sense, from a public policy perspective, to encourage the buying and selling of property so that business owners purchase the property that is best suited for their use. Property may include real estate, personal property such as equipment, tools and motor vehicles, or livestock, for example. The government, recognizing that the possible capital gain taxes on the sale of property might prevent some businesses from buying and selling property, has enacted what is known as the 1031 Exchange Rule. What is the 1031 Exchange Rule? The 1031 exchange rule is part of the IRS Code. It allows people to replace business or investment property without having to pay capital gains taxes at the time of the sale. It is meant to encourage the productive use of property in trade and business. Property that is bought with the intent of creating a quick resale and private residences will not qualify for a 1031 exchange. The potential tax benefits of a 1031 exchange are significant. Therefore, the IRS has established some strict guidelines about the types of properties and the types of transactions that are eligible for this tax break. Does My Transaction Qualify as a 1031 Exchange? If you are trying to determine whether your real estate transaction would qualify as a 1031 exchange then consider:

• Whether the properties involved in the exchange are held for valid trade, business or investment purposes;
• Whether the properties qualify as eligible for a 1031 exchange. Section 1031 b of the IRS Code explains what is and is not eligible for a 1031 exchange. For example, real estate is eligible but stocks and bonds are not eligible;
• Whether the properties are of like kind. For example, both properties are real estate in the United States and not other types of personal property or international real estate.
• Whether you identified the replacement property within 45 days of closing on your current property and closed on the replacement property within 180 days of closing on your other property.
• Whether the proceeds from the sale of your current property must go to a qualified intermediary until you purchase your replacement property. The qualified intermediary enters a written contract with the person who is buying and selling property. The qualified intermediary holds the funds from the sale of a property and acquires the next property and then transfers the property to the taxpayer.

All of the funds must be reinvested in the replacement property. Any cash that is left over after the purchase of the replacement property is called “boot” and will be taxed. As is the case with many tax breaks, the requirements for a 1031 exchange are strict and the penalties for not complying with all of the requirements can be significant. It is, therefore, important to work with an attorney versed in 1031 exchnages before entering a 1031 exchange transaction. If you don't have one or are not currently working with one, you can give me a call and I will recommend one that we have that we can recommend. The attorney can make sure that all of the requirements have been satisfied and that the exchange is made pursuant to section 1031 for the benefit of your business.