Real estate investments offer a number of tax benefits to its investors. IRS code 1031, also called as a like-kind exchange, allows for tax deferred sale of one investment or business property for the purchase of another. And there’s no limit to how often you can make this type of exchange, so you can make several profitable real estate investments, deferring capital gains indefinitely if you don’t cash out of the property.
What are the rules?
The two properties must be “like-kind business or investment properties. It doesn’t apply to a personal residence. Like-kind property can be any property held for productive use in a trade or business or for investment. Any type of investment property can be exchanged for another type of investment property. For example, a single-family residence can be exchanged for a duplex, or a small apartment building can be exchanged for a larger one. There is flexibility in what constitutes “like-kind”, as well so you could exchange an office building for an apartment.
45 and 180 days.
Within 45 days following the sale of a property, you must identify potential replacement properties where you will invest all proceeds from the sale. You can identify up to 3 properties worth any amount to invest in. Or you can identify more than 3 properties, if their total value doesn’t exceed 200% value of the property sold.
You then need to close on the purchase of the new (exchanged) property within 180 days following sale of the prior.
The owner must be the same on both properties to comply. If Brenda Johnson, LLC owns the original property then Brenda Johnson, LLC must be the purchaser of the exchange property.
The 1031 Exchange Process
The steps to perform a 1031 exchange follow.
1: Is the property you want to sell is a good fit for a 1031 exchange?
You need to evaluate the property for sale to determine if a 1031 exchange makes sense. You should engage your CPA to evaluate the property for sale is a fit. If so, proceed with planning for the exchange.
2: Contact a qualified intermediary.
A 1031 exchange qualified intermediary is a company that facilities 1031 exchanges. They will manage the process of the exchange including records for the identified replacement properties and escrow of funds between sale of the first and purchase of the exchange property.
3: List your property for sale.
You would be doing this anyway without a 1031 exchange, so we’re not going to elaborate on it here as it’s not 1031-specific.
4: Search for replacement properties early.
You only have 45 days from the time you sell your first property to identify potential replacement properties. That’s not a lot of time. So begin looking for replacement properties as soon as you’re considering an exchange. In the best case you’ll have identified multiple potential properties while in the process of selling the first.
5: Sell the first property.
This is similar to a standard sale, but your qualified intermediary will hold the sales proceeds for you in a special account. This account will distribute funds for the purchase of the replacement property.
6: Identify your replacement property or properties within 45 days of selling your relinquished property.
You will identify these properties to your qualified intermediary.
7: Purchase your replacement property or properties, working with your qualified intermediary, within 180 days of selling your relinquished property.
You will fund the purchase from the escrow account noted above. Additional funds can be added if needed.
That’s it! You now own a new property, deferring taxes on the gains from the sale of the previous one. And you can repeat this process indefinitely, based on the current rules.