Purchasing Investment Property Using A 1031 Exchange

Generally, when one sells investment property, they must pay capital gains on the profit generated by the sale.  However, there are provisions of the Internal Revenue Code (IRC) that allow for the investor to defer the gain on the sale under certain circumstances.  Using a 1031 exchange, an investor can sell one property and then buy a replacement property and defer the tax on all the gain.  It is called a 1031 exchange because it is provided for in section 1031 of the IRC.  This article will outline the type of transactions that qualify for a 1031 exchange and some of its basic principles.

A 1031 exchange is also called a like-kind exchange because it can only be used when exchanging the same type of property.  This does not mean that both properties have to be identical in nature.  That is, the properties don’t both have to single-family homes or warehouses.  The like-kind requirement is satisfied if both properties are investment properties.  The 1031 exchange can only be used for investment property.  It cannot be used in the sale of one’s primary residence, although there are other ways to avoid the capital gains tax on the sale of a primary residence if certain conditions are met.

There are several reasons why an investor may want to use a 1031 exchange, whether it’s to diversify a portfolio, change the type of property (condo to apartment, warehouse to apartment, etc.).  However, the main reason why investors use the 1031 exchange is for the tax deferral.  The tax can be deferred until the investor ultimately cashes out, or forever if the exchange is properly structured.

When structuring a transaction for a 1031 exchange it is critical to meet the deadlines imposed by the IRC and to understand some of its basic terms.  Relinquished property, as the name implies, is the property that is being exchanged (sold).  Replacement property is the property that is bought with the proceeds from the sale of the relinquished property.  Once the relinquished property is sold, the investor has 45 days to identify the replacement property and 180 to close on the sale.  There are several provisions that govern the number and value of the property that dictate whether it qualifies as a replacement property.  It also important be mindful of the fact that if the replacement property is not of equal or greater value than the relinquished property, the investor will have to pay capital gains tax on the difference.

In order to qualify for a 1031 exchange, the investor cannot receive the proceeds of the sale of the relinquished property.  They have to be held by a third-party until the closing of the replacement property.  The third-party cannot be the investor’s attorney or CPA, and must be a neutral, third-party.  In the majority of 1031 exchanges, a qualified intermediary is used.  A qualified intermediary is a third-party entity that receives the proceeds and keeps them in trust until the closing of the purchase of the replacement property.  If the investor receives the proceeds from the sale of the relinquished property before sending them to the qualified intermediary, the transaction will not qualify for a 1031 exchange and the investor will have to pay capital gains tax.

The 1031 exchange process is complicated and can present challenges for even a seasoned investor.  It is critical to obtain the proper tax advice and legal counsel to ensure that the transaction is properly structured so the 1031 exchange is not invalidated, which could result in a large tax liability.  Barbosa Legal has a team of highly trained tax, real estate, and corporate attorneys and professionals and regularly counsels clients in the structuring and execution of 1031 exchanges.

Real EstateMaria Moller