What is a 1031 Exchange?
When real estate is sold, the seller pays federal tax on any gain or deducts for losses. Section 1031 of the tax code gives taxpayers an opportunity to defer any gain on the sale of qualified property. Most exchanges are completed through a company that specializes in 1031 exchanges (an intermediary). The IRS has published rules (safe harbor rules) for an intermediary assisted exchange. If these rules are followed, the IRS will not challenge the exchange. This safe harbor is a primary reason for using an intermediary to assist in the exchange.
The 1031 exchange provision is only for investment and business property, so you can’t swap your primary residence for another home. There are ways you can use a 1031 for swapping vacation homes, but this loophole is much narrower than it used to be. Most 1031 exchanges involve real estate, however, some exchanges of personal property (say a painting) can qualify. Note, that exchanges of corporate stock or partnership interests don’t qualify. On the other hand, interests as a tenant in common in real estate do.
Most exchanges must merely be of “like-kind”, a phrase that doesn’t mean what you think it means. You can exchange an apartment building for raw land, or a ranch for a retail center. The rules are surprisingly liberal. You can even exchange one business for another but again, there are traps for the unwary.
There is a six month period (180 days) to complete an exchange. When an intermediary is used, an exchanger may convey the sold property (relinquished property) directly to a purchaser with the proceeds of the sale paid directly to the intermediary. When the exchanger purchases the replacement property, the intermediary pays the exchange funds to the seller of the replacement property. Title to the property usually does not pass through the intermediary.
Under Section 1031 tax on a gain is deferred, not completely forgiven. Eventually when the replacement property is sold, tax on the deferred gain must be paid unless other provisions of the tax code are used to completely eliminate the taxable gain.
There are two critical time periods for exchanges: the identification period and the exchange period. Both begin on the date the relinquished property is sold and run concurrently.
The identification period is 45 days. During this 45 day period replacement property must be designated or identified in writing. If replacement property is not identified within this 45 day period, the exchange fails and all gain realized from the sale of replacement property will be taxable.
The exchange must be completed within 180 days of the closing date for the relinquished property. This 180 day period runs concurrently with the 45 day designation period. It is not added to the end of the designation period. It is not possible to extend either the identification period or the exchange period.
If the exchanger files a tax return for the year of the exchange, the exchange period is terminated. If an exchange has not been completed by the date a tax return is due, a request for an extension of time to file the tax return must be filed in order to receive the entire 180 day period to complete an exchange.
Steps to Follow
After the sale of the relinquished property, the sales proceeds are required to be sent to the qualified intermediary pending the purchase of the replacement property.
Identify replacement property within 45 days of the sale of the relinquished property. After the 45 day identification period, only property identified as potential replacement property qualifies as replacement property.
Contract to purchase replacement property.
Notify the intermediary of the contract to purchase replacement property and provide information about the closing of the purchase.
Within 180 days of the date of sale of relinquished property, purchase the replacement property, using exchange proceeds held by the intermediary.
The 180 day purchase period runs concurrently with the 45 day identification period.
Link to info for Like-Kind Exchanges Under IRC Code Section 1031 at the IRS.