Before defining a 1031 exchange, we must first address capital gains. A capital gain is an economic concept defined as the profit earned on the sale of an asset which has increased in value over the holding period. An asset may include tangible property such as real estate, a car, a business, or intangible property such as shares. Typically, when a person realizes capital gains it is a taxable event. Under Section 1031 of the United States Revenue Code, a taxpayer may defer recognition of capital gains and related federal income tax liability on the exchange of certain types of property, a process known as a 1031 exchange.
Steps in a 1031 exchange
- Step 1: IRC section 1031: Section 1031 of the Internal Revenue Code permits investors to defer the payment of tax on the gain from the sale of property held for productive use in business, trade or investment, provided that the property is exchanged for a “like kind” asset or assets. The section creates a “safe harbor” that permits the taxpayer to have assurance that the transaction will permit the deferral of the capital gain tax payment.
- Step 2: Select a Qualified Intermediary: A requirement of the IRS is that the proceeds from the sale of the property be held by a qualified intermediary until the replacement property is purchased.
- Step 3: Include the exchange cooperation clause as an addendum to the contract: It is important to include language in the contract of sale for both the sale of your relinquished property and the purchase or your replacement property that requires the counter-party to cooperate in the exchange.
- Step 4: The intermediary signs the closing documents at settlement.
- Step 5: The transfer of deed goes directly from the seller to the buyer.
- Step 6: Within 45 of settlement, the investor must notify the intermediary in writing of the potential replacement properties.
- Step 7: Investor has 180 days to purchase one or more of the replacement properties: This deadline may actually be sooner if tax filing is done before the 180 day expiration period.
- Step 8: Any remaining funds left over are returned, but are taxable: If there are still proceeds left over from the subsequent investment property, these funds are considered taxable.
- Step 9: Requirements for deferring the entire taxable gain: Value of replacement property must be equal to or greater than the value of the relinquished. In addition, the equity in the replacement property must be equal to or greater than equity in the relinquished property. Debt on the replacement property must be equal to or greater than debt on the relinquished property. Lastly, all of the net proceeds must be used to acquire the replacement property.
A 1031 exchange can be an important part of any real estate portfolio. As always, we recommend consulting an intermediary that focuses on 1031 exchanges when considering this strategy. The future of the 1031 exchange program has been in question, particularly with the new administration. With this said, given the fragility of the overall economy due to the pandemic, many believe that it will remain as an option for the foreseeable future.
Should you have any real estate questions or needs in South Florida, we are here to assist. Feel free to contact Live South Florida Realty, Inc. today!