What is an IRC section 1031 Tax Exchange?
The 1031 tax exchange, as explained in Section 1031 of the Internal Revenue Code (IRC) of 1986, as amended, offers investors one of the last great opportunities to build wealth and save in taxes.
IRC Section 1031 tax exchange Explained
By completing an exchange, the investor (Exchanger) can dispose of their investment property, use all of the equity to acquire qualifying 1031 replacement property, defer the capital gain tax that would ordinarily be paid and leverage all of their equity into a replacement property and or properties.
Two requirements must be met to defer the capital gain tax: (a) the Exchanger must acquire "like kind" replacement property and (b) the Exchanger cannot receive cash or other benefits (unless the Exchanger pays capital gain taxes on this money).
In any IRC section 1031 tax exchange, the Exchanger must enter into the 1031 tax exchange transaction prior to the close of the relinquished property and or properties. The Exchanger and the Qualified Intermediary enter into an Exchange Agreement, which essentially requires that (a) the Qualified Intermediary acquires the relinquished property and or properties from the Exchanger and transfers it to the buyer by direct deed from the Exchanger and (b) the Qualified Intermediary acquires the 1031 replacement property and or properties from the seller and transfers it to the Exchanger by direct deed from the seller.
The cash or other proceeds from the relinquished property are assigned to the Qualified Intermediary and are held by the Qualified Intermediary. The exchange funds are used by the Qualified Intermediary to purchase the 1031 replacement property for the Exchanger.
Important Considerations for an IRC section 1031 Tax Exchange
- Exchanges must be completed within strict time limits. The Exchanger has a set 45 days from the date the relinquished property closes to "Identify" potential replacement properties. This involves a written notification to the Qualified Intermediary listing the addresses or legal descriptions of the potential replacement property and or properties. The purchase of the 1031 replacement property must be completed within 180 days after of the close of the relinquished property. After the initial 45 days has passed, the Exchanger may not change their Property Identification list and must purchase one of the listed replacement properties or the exchange fails!
- To avoid the payment of capital gain taxes the Exchanger should follow three general rules: (a) purchase a replacement property and or properties that is the same or greater value as the relinquished property, (b) reinvest all of the exchange equity into the replacement property and (c) obtain the same or greater debt on the replacement property as on the relinquished property. The Exchanger can offset the amount of debt obtained on the replacement property by putting the equivalent amount of additional cash into the exchange.
- The Exchanger must sell property and or properties that are held for income or investment purposes and acquire 1031 replacement property that will be held for income or investment purposes.
- IRC Section 1031 does not apply to exchanges of stock in trade, inventory, property held for sale, stocks, bonds, notes, securities, evidences of indebtedness, certificates of trust or beneficial interests, or interests in a partnership.
