IRS Section 1031 Exchanges – Tax-deferred Exchanges
If you are considering selling real estate that will produce a taxable gain, you may want to consult your tax adviser about IRS regulation 1031. This provision allows taxpayers to exchange properties of equal or lesser value to defer the tax liability.
1031 exchanges are simply a way to move money from one property to another without incurring capital gains tax. Section 1031 has been part of the tax code since 1921, only three years after income tax was introduced in 1918. The present-day version of section 1031 was created with the 1954 tax code.
Below is general information on terminology and procedures involved in qualified exchanges:
- Eligible Properties – have to be of like kind, which means income producing real estate owned by individuals. For example, an apartment house could be traded for a farm or a commercial building.
- Initial Offers to Purchase – must contain language stating that the seller intends to use Section 1031.
There are two methods of executing an exchange:
- Older Method – involves actually trading deeds for the different properties at a common closing. However, these transactions are hard to effect, requiring coordination and closing several real estate transactions simultaneously.
- Newer, Easier Method – uses the services of a qualified intermediary as an escrow agent to “park” money from the sale of the first property while identifying and arranging the purchase of the replacement property.
The following items concern the use of the Qualified Intermediary agent concept:
- Real Estate agencies, attorneys, banks, and individuals can all serve as qualified intermediaries if proper agreements are executed. Typical charges for this service are usually $1,000 or less. The escrow account where the money is deposited can earn interest. If a bank is selected as the intermediary, the bank should not be involved in financing either of the properties.
- The Qualified Intermediary will actually buy the next property with money from the escrow account at the principal’s direction. The funds cannot become available to the principal, or 1031 rules are violated and the gain on the sale will become taxable.
- From the date of closing the sale on the first property, the seller has 45 days to identify potential replacement properties. It is imperative that the identified properties be available for purchase and that the replacement property is selected from those identified.
- The seller has 180 days to close on the replacement property from the date of closing the sale of the original property.
“Reverse” exchanges can also be done (aka “Starker” or “non-simultaneous” exchanges). This process was determined to be legal by a 1979 court case. This involves buying a property first, then selling another property and using those funds toward the purchased property. This is a considerably more complicated procedure than a “straight” exchange. Not all Qualified Intermediaries will participate in reverse exchanges.
We can help complete real estate exchange transactions which reduce or eliminate tax liability. Call today to discuss the advantages of the process.