One of the critical considerations for owners of investment property is the requirement to pay a capital gains tax upon the sale of the property. Given the advances real estate prices have made in recent years, such a tax payment could be sizable. There are ways to avoid these taxes, such as entering into what is referred to as a 1031 Exchange. Let’s take a look at some of the basics.
A Primer on 1031 Exchanges
Under Section 1031 of the Internal Revenue Code, the owner of an investment property can sell the property and use the proceeds to invest in another property without having to pay the capital gains tax, provided that all of applicable requirements of the Code are followed.
In short, a 1031 exchange is essentially a rollover, and the tax is deferred until the second property is sold at a profit. It is important to note that these transactions only apply to investment and business properties, and not personal residences. At the same time, It is possible to convert a residence to an investment property and structure it as a 1031 exchange.
Additionally, the Code requires the exchange must be for a property of “like kind.” Nonetheless, the term like kind is interpreted broadly, and an investor can exchange the property for land, commercial property and other similar investments.
Some investors mistakenly believe that the exchange must be made simultaneously, however this is not case. In fact, most exchanges are deferred, and the proceeds from the sale of the property are held by an intermediary, such as a trust company or other fiduciary, while the investor looks for an exchange property.
Nonetheless, the investment in the exchange property must close within 6 months. Upon the sale of the first property, the investor must designate up to three potential exchange properties within 45 days of the closing, and then has 135 day to select and close on one of them.
The Bottom Line
Although 1031 exchanges can potentially save real estate investors thousands of dollars, these transactions are underutilized because many individuals do not understand how they work. If you own an investment property and are considering selling it, an experienced real estate attorney can advise you on how to conduct a proper 1031 exchange.