1031 tax exchanges are advantageous to investors.
The tax code known as the 1031 exchange allows real estate investors to defer payment of taxes on the sale of an investment property. By exchanging one investment property for another, the Internal Revenue Service (IRS) allows owners to postpone the taxes normally due to be paid until a later date. Primary residences do not qualify for a 1031 tax exchange; only properties purchased as investments or for business purposes qualify under IRS guidelines.
Definition of Like-Kind
The properties exchanged under 1031 rules must be of "like-kind," according to the IRS. This is defined as properties of the same nature or character, even if they differ in grade or quality. Vacant land sold and exchanged for a single-family residential rental property is an example of a like-kind exchange as defined by the IRS. Other examples include an exchange of city property for farm property or improved property (with a home or building) for unimproved property (vacant land). Property located outside the United States is not a candidate for a like-kind exchange for 1031 tax purposes.
Identification of Replacement Property
The clock begins ticking from the day the divested, or sold, property closes. You have 45 days from that date to identify up to three replacement properties as potential candidates to purchase with the profits from the sale of the divested property. At the end of 180 days from the date the divested property closes, you must receive ownership of the new property. This 180-day period is known as the exchange period. If you plan to purchase more than one replacement property, the total fair market value of all properties may not be more than double the fair market value of the properties sold.
Handling of Money
An exchange facilitator must handle the money to be transferred under a 1031 tax exchange. This third party holds the funds from the sale of the divested property and transfers the funds to the appropriate party to complete the sale of the replacement property. The terms of the exchange should be detailed in an escrow, trust or exchange agreement and held in a qualified account for this purpose. Most exchange facilitators charge a fee for this service. As the seller and subsequent purchaser, you may not have actual receipt of or direct access to the funds during the exchange process. People who are disqualified from serving as this third party include an agent who represents you such as an accountant, real estate agent or lawyer, as well as those related to you or one of your agents.
