A 1031 Exchange, otherwise known as a “Like-Kind” Exchange, is a strategy used by successful investors in order to defer capital gain taxes when selling investment property. In 2018, as property prices continue to fluctuate, many investors feel that it is the right time to sell their investment properties in high-priced areas in order to maximize profits while looking for the next big market. However, the one drawback of this strategy is the abundance of capital gains taxes due to the significant rise of real estate prices. This is where the 1031 Exchange becomes an investors ally, and allows the investor to defer any capital gains until much further in the future.
The term 1031 Exchange stems from Section 1031 of the Internal Revenue Code, and it allows an investor to defer the payment of capital gains taxes on the sale of an investment property by utilizing the net proceeds of any scale of such investment property to purchase a “like-kind” replacement property. This means that if an investor sells their high-priced condo in New York City for $2,000,000 after purchasing that same condo for $500,000, rather than paying capital gains taxes on the $1,500,000 profit, they can instead use the proceeds to purchase one or more “like-kind” replacement properties anywhere they see fit, and defer the payment of the capital gains taxes until the sale of the replacement properties (unless the investor so chooses to utilize an additional 1031 Exchange, the property being sold must not be the seller’s primary residence.
The 1031 Exchange method has many strict rules which the investor must follow. First, the investor hires a third party known as a “qualified intermediary” to hold the net proceeds of the first sale. Note: It is vitally important that the investor never actually have access to the net proceeds of the sale, as this would invalidate the 1031 Exchange. After the sale of the investment property has been completed, the investor then has 45 days to “identify” a replacement property or properties to purchase with the proceeds, and further, has 180 days to consummate the transaction.
After reading the description, the question which must be asked is how do I know if the property I am looing to purchase is “like-kind”? The Internal Revenue Service defines “like-kind” as having “the same nature or character, even if they differ in grade or quality.” This means that you cannot exchange your New York City condominium for a prized Pete Rose rookie baseball card. However, it does not mean that you can’t exchange your New York City condominium for an Austin, Texas house. This is because for real estate investments, the Internal Revenue Service has deemed that any exchange will most likely be valid so long as real estate is exchanged for real estate, as long as it’s not personal property. However, the real estate purchased must be within the United States of America as per the Internal Revenue Code.
As you may be able to tell, 1031 Exchanges can be incredibly useful to investors, but also have strict rules which must be followed in order to successfully defer the payment of capital gains taxes on the sale of investment property. For more information, and for legal guidance please call Bashian & Farber, LLP.