Section 1031 is a provision of the Internal Revenue Code that allows business or investment property owners to defer taxes on some exchanges of real estate. The transaction, called a 1031 Exchange, often garners a review when there is a change in political leadership. Over time administrations, regardless of party affiliation, have considered repealing the 1031 Exchange in an effort to make more funds available for other programs. Time and again, they determine that the economic benefits of the 1031 Exchange are too strong to repeal it all together. Hence, its 100-year tenure! Here are a few more details on a 1031 Exchange and why it matters.
Like-kind investments
When an investor sells a business or investment property that has benefited from appreciation, he or she is required to pay a capital gains tax on the appreciation at the closing of the sale. However, if those gains are reinvested into a like-kind investment (a 1031 Exchange), those taxes can be deferred. For example, a small multifamily investor can reinvest the proceeds from the sale of a four-plex to purchase a larger building with more units leveraging the economies of scale.
There are statutory rules and regulations associated with a 1031 Exchange and because of this, clear and accurate communication with your team is important. This team includes your broker, accountant, attorney and a third-party qualified intermediary (“QI”). A QI must be a neutral third party that doesn’t have a major conflict of interest in the transaction. The QI facilitates the completion of a 1031 Exchange. According to the IRS definition this team member:
Holds the sale proceeds in escrow,
Watches for and alerts to red flags to ensure compliance,
Ensures all exchange steps and documentation occur in a timely manner and according to statute.
Strategies to consider for 1031 Exchange compliance
When you sell a property and wish to defer the taxes by purchasing another property here are some strategies available to you that are compliant with the 1031 Exchange according to the IRS:
Close on the sale and purchase on the same day.
If you have not identified a property to purchase, your sale proceeds can be escrowed with the qualified intermediary. In this case you must identify properties for purchase within 45 days and you must close on one or more of those properties within 180 days of the sale of the first property.
Reinvest sale proceeds into a REIT, or similar real estate fund.
Utilize a Reverse 1031 in which the property is purchased first through the qualified intermediary.
As you can see, a 1031 Exchange can be a bit complicated, but with an experienced team of professional can be an important vehicle to optimize your real estate investment portfolio.
Give us a call if you are interested in completing a 1031 Exchange transaction.