Purchased property can increase its value. For example, if you bought property in the 1970’s for $100,000.00 and the same property is worth 600,000.00 today, then your property has appreciated, or grown, in value. The Federal government taxes this increase in value through a capital gains tax. Depending on your tax bracket, the capital gains tax begins at 15% and increases from there. If we use the example above, you could pay over $100,000.00 in capital gains tax on the sale of property. That is more than what you originally paid for it! A 1031 Exchange is a way of deferring the capital gains tax.
What is a § 1031 Exchange?
A § 1031 Exchange is a transaction in which a person is allowed to exchange one property for another. This exchange defers, or pushes back, the payment of the capital gains tax until that person chooses to sell the new piece of property.
Who Qualifies for a § 1031 Exchange?
The I.R.S. has made a § 1031 Exchange available to the following:
- C corporations,
- S corporations,
- Partnerships (general or limited),
- Limited liability companies,
- Trusts, and
- Any other taxpaying entity
Same Taxpayer Rule
In order to take advantage of a 1031 Exchange, the names on the tax return, title of property being sold, and the property being received must all be the same. The only exception to this rule is in the case of a single member limited liability company. The single member and the member as an individual are treated as the same person for purposes of a 1031 Exchange.
What Property Qualifies for a 1031 Exchange?
If you choose to undertake a 1031 Exchange, the property you receive as part of the exchange must be “like-kind” to your original property. The I.R.S. has defined “like-kind” to be of the same nature, character, or class as the original property. This is a very broad definition, but the important part is that real property is not like-kind to personal property. For example, farm equipment would not be like-kind to farm ground.
Of Equal or Greater Value
In order to keep the exchange free from capital gains, the property you receive as part of the exchange must be of equal or greater value to the property you are giving up. The equal or greater value rule would include a mortgage. For example, if your current property is worth $500,000.00 and has a $100,000.00 mortgage on it, then the new property you receive must be worth at least $500,000.00 and your mortgage of $100,000.00 will need to carry over.
Business or Investment Property Only
Property that is used for a 1031 Exchange cannot be for personal use. The property must be part of your business or investment property. For example, you cannot exchange your personal residence for a new residence under a 1031 Exchange. Both properties would be considered personal. You can exchange a rental property for a new rental property. That would be an exchange of investment property.
Timeline of the Exchange
There is a strict timeline that you must follow in order to take advantage of a 1031 Exchange. Specifically, you have 45 days from the sale of your original property to identify replacement property of equal or greater value. The IRS has particular notice requirements that you must satisfy in order to successfully complete the exchange. Once identified, you have 180 days from the day you sold your original property to acquire the property you identified as a replacement. Compliance with the timeline requirements is necessary to a successful 1031 Exchange.
A § 1031 Exchange is an incredibly useful tool for someone facing capital gain tax from the sale of property. However, the exchange procedures are strict and must all be met in order for the exchange to be acceptable to the IRS. An attorney from our office would be happy to shepherd you through the process and insure that you meet all of the requirements for a successful 1031 Exchange.