A 1031 Exchange Could Save You a Ton of Tax!

I'm constantly amazed at how many millions, probably billions, of dollars are paid in taxes each year by people who could avoid all of the tax on the sale of their property by taking a few simple steps. Section 1031 is such a beneficial part of the Internal Revenue Code that it’s a shame most tax and legal professionals don’t know about it. And many of those who are aware of it don’t really understand it.

Section 1031 is a code section—its law, not some theory or gimmick. It allows you to roll the gain from the sale of your “old” investment property into the purchase of your "new" investment property. In other words, you defer the gain until some point in the future when you are ready to pay the tax. And yes, there are ways that will result in you having to never pay the tax.

Investment property is defined as property that you’ve held for rental income, appreciation or business use. Typically, you must hold both the old property and the new property for at least a year and a day to satisfy the holding periods. It you buy a property, fix it up, and then set it s few months later, you are not eligible for Section 1031. Developers are not eligible for 1031 exchanges either.

If you want to stay out of trouble with the IRS, you need to know the six main things they look for when they audit an exchange (and they are particular about these requirements!):

Rule #1 - both the old property and the new property must be like-kind property held for investment. Like-kind property is defined quite broadly; therefore, you may sell one type of investment property and buy a different kind of investment property. For example, you can sell bare land to buy an apartment building, sell an office building to buy a vacation home [1031 vacation home update: May 2007] or sell a warehouse to buy bare land. Remember, your personal residence and property held for resale are not considered investment property.

Both the “old” end “new” properties must be located inside the United States, or both of the properties need to be outside of the US. For example, if you sell in Hartford, CT, you can buy in Honolulu, HI. However, selling in The Hamptons and buying in Toronto would not qualify.

Rule #2 - from the day you close the sale of your old property you have 45 days to complete a list of properties that you may want to buy. The list needs to identify the property clearly enough that an IRS agent could walk up to the property based on your written description (street address or legal description). A good rule of thumb is that your list should include three or fewer properties.

Rule #3 - again from the day you close the sale of your old property, you have 180 days to close on the purchase of one or more of the properties from your 45-day list. Both the 45 and 180 day time frames are cast in concrete—there are no exceptions or extensions.

Rule #4 - you can not couch the money in between the sale of your old property and the purchase of your new. By law, you must use an independent third party, called a Qualified Intermediary, to hold your proceeds. The qualified intermediary will also prepare the legal documents required to link together the sale of the old property and the purchase of the new as a qualified exchange.

How do you pick a qualified intermediary? Look for one that uses segregated qualified escrow accounts – This is VERY important.  There are no laws governing intermediaries, so also look for knowledge & reputation. It’s what you don’t know that will get you into trouble.

Also, be sure that they hold your money in a separate account. Commingling your funds with other exchangers’ money adds significant risk to the security of your funds.

Rule #5 - you must take title to the “new” property in exactly the same way that you hold title to the “old” property. If you hold the old property as Fred Jones, you cannot buy the new property as Jones Investment Corporation. There are some exceptions to this rule for situations like revocable living trusts.

Entities like corporations, partnerships, LLCs and trusts may do 1031 exchanges. Foreign investors who own real estate in the United States are also eligible. If a foreign investor does a 1031 exchange, the 15% FIRPTA withholding tax is abated.

Rule #6 - in order to defer 100% or the capital gains tax, you need to meet two requirements. First, you need to buy a property that is equal or higher in value than the one you sold. Second, you need to reinvest all of the proceeds from the sale into the new property If you purchase a lower valued property (buy down) or if you don’t reinvest all of the proceeds (boot), you pay tax on the amount of the decrease and the amount of cash taken out of the transaction. All of the difference is subject to tax because in a 1031 exchange the gain is taxable first. Although, the good news is that the buy down (or “boot” as the IRS calls it) is eased at capital gains rates.

There is no limit to how many times you can do an exchange; you just have to hold each property for a year and a day. So the bottom line is this, if you plan to buy more real estate with your proceeds, a 1031 exchange is the only way to go.