When you sell an investment property and buy another one, you may end up with a large capital gain. That's great, but you may have to pay federal and/or state taxes on the gain. To offset the tax liabilities, your tax advisor, attorney, or real estate broker may suggest you participate in a tax-deferred exchange under Section 1031 of the Internal Revenue Code.
A 1031 tax exchange allows you to defer the payment of capital gains taxes by selling a property and then acquiring a "like-kind" property. This means that the property you purchase has to be similar to the one you sell. To be fully tax-deferred, the property you purchase must have value and equity equal to, or greater than, the property you are selling.
The Internal Revenue Service (IRS), by allowing 1031 Tax Exchange, gives taxpayers a way to sell investment property first and then use the funds after the fact to acquire more property without being taxed on the gain from the sale. In other words, the 1031 Exchange allows you to reinvest the proceeds from the sale that would otherwise be paid as capital gains taxes.
Real or personal property can be exchanged provided it is held "or productive use in a trade or business", or "for investment" and exchanged for property that is like-kind that will also be held for one of the same purposes.
There are rules that must be followed:
•You and the buyer of your property must enter into a Relinquished Property Purchase Contract that contains a "cooperation clause" that obligates the buyer to cooperate in the structuring of the contract as a tax-deferred exchange.
•Legal documents must be prepared by a Qualified Intermediary. There must be an Exchange Agreement, an Assignment of the Relinquished Property Purchase Contract, A Notice of the Assignment, and instructions to the settlement agent, either a qualified escrow agent or attorney.
•All documents must be signed before or as of the date of closing. Once the escrow is closed, the escrow agent or attorney then transfers your funds to the intermediary. At no time should you be in receipt of any of the cash proceeds.
•The property you are buying must be identified within 45 days of the transfer of title of the relinquished property in which you are selling. The purchase of your replacement property must be completed within 180 days from the date of the transfer of the relinquished property or the date of your tax return for the year in which the title of the relinquished property was transferred.
•After identifying your replacement property, you must enter into a Replacement Property Purchase Contract with the seller. The contract should also contain a "cooperation clause" which obligates the seller to cooperate with you in completing the tax-deferred exchange.
•The intermediary should then prepare an Assignment of the Replacement Property Purchase Contract, Notice of the Assignment, and instructions to the escrow agent or attorney. All documents must be signed before or as of the date of closing.
•Once all the conditions of the escrow has been met, the intermediary will deliver the exchange proceeds to the escrow agent or attorney. The title of the Replacement Property will be transferred to you in completion of the exchange.
Although the rules for participating in a 1031 Tax Exchange are relatively simple, unless you have experience with such projects, it is highly recommended that you use the services of a professional who is qualified in such matters.