A 1031 tax deferred exchange is a real estate transaction defined by the Internal Revenue Service. It is a particular type of transaction which involves the exchange of business or investment property for a similar property. In other words, to be eligible under 1031 exchange guidelines you must be exchanging an existing investment property that you own for another investment property that is similar in most aspects. This is the reason why 1031 exchange is also referred to as a “like-kind” exchange.
When a transaction qualifies as a 1031 transaction, there are tax benefits associated with the exchange. Per the Internal Revenue Service Code Section 1031, there is no gain or loss that must be reported on the exchange values of the property. If you exchange property and also exchange money or property that is not like-kind, you will have to recognize a gain on the additional value. You would not be allowed to recognize a loss though.
So Much Alike
The definition of like-kind property is spelled out in the IRS regulations. The property that is exchanged must be of the “same nature or character” per the IRS. The property can be of a different grade or quality and still be considered like-kind. You cannot exchange a personal residence in a 1031 transaction for another personal residence or investment property.
The obvious advantage of a tax deferred exchange is the fact that capital gains taxes are deferred as long as any funds involved are used in the exchange. You are allowed to exchange one property for several properties as long as all the properties involved are like kind. You can also buy a single property using the proceeds from the sale of multiple properties, once again as long as all the involved properties qualify under the IRS regulations.
1031 Tax Deferred Exchange Benefits
In 1986 the internal revenue service created section 1031 of the internal revenue code. While it has since had minor amendments, 1031 tax deferred exchange services were created to assist investors interested in saving on taxes. Section 1031 saves on taxes for the exchanger (investor) by allowing an exchange of one property for another while deferring the capital gains tax.
Transfer of equity
In addition to temporarily avoiding the capital gain tax, 1031 exchanges allow investors to take the equity they have accumulated in their current property and transfer it into the new property involved in the transaction. This is a benefit to the purchaser, because it allows him or her to have increased transactions with decreased taxes, therefore helping to boost the real estate economy. That was one of the purposes of the 1031 section. When purchasing the new property, the buyer needs to begin the 1031 process prior to the closing on the new property.
It is the job of the Qualified Intermediary to attain the deed from the previous property and directly move it into the ownership of the buyer. The money received from this transaction is held in the care of the Qualified Intermediary, who is responsible for purchasing the new property on behalf of the exchanging party. The Qualified Intermediary is also responsible for attaining the deed of the new property and bringing that deed to the exchanger directly from whoever is selling that property.
One important thing to keep in mind is the narrow time frame that an exchange must be completed in order to qualify for the tax benefits. It is better to have a new property in mind before beginning the 1031 exchange process, which may be difficult at times if a buyer has already been identified for the old property. This process must be completed and should have been closed within six months of the beginning of the exchange process, with the new property being identified within the first forty-five days.
It is important to remember the value of the properties. It should also be remembered that it is required to reinvest all equity created in the first property into the new property. Additionally, in order for the exchange to be applicable with 1031 tax deferred exchange services, the exchanger must be incurring the same amount or an increased amount of debt as he/she had from the previous property.
When you are interested in completing a 1031 tax deferred exchange, a title insurance company can be instrumental in assisting you with the transaction. A 1031 exchange must be carefully recorded and documented in order to satisfy the IRS. The title company can do title searches, issue title insurance, provide settlement services and act as escrow agent.
Understanding the definition of the 1031 exchange and proving one exists are two different processes. With the assistance of a title insurance agent, you can rest easy knowing you are getting the best real estate service possible.