Understanding the “Tax-Free” 1031 Exchange

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Understanding the “Tax-Free” 1031 Exchange
Real Estate

Section 1031 of the Internal Revenue Code allows you to defer paying taxes on any gain realized on the sale of investment property if you reinvest those proceeds back into a new property.  This is called a “1031 exchange” — although it really acts more like a rollover than an exchange.

Since they can be a bit tricky, you really need the help of a real estate attorney to successfully execute a 1031 exchange.  Still, there are some general rules you need to know about a 1031 exchange:

You can’t use a 1031 for your personal residence.  You can only use a 1031 for investment and business property.

Some personal property does qualify.  Most 1031 exchanges are used for real estate, but you can use a 1031 for personal property, like a valuable painting.

Exchange must be “like-kind”.  Properties swapped in a 1031 must be of “like-kind,” but that definition is broad.  It refers to the use of the properties — both the old and new must be used for investment or business purposes.  You don’t have to exchange an office building for another office building — you can swap for undeveloped land or an apartment building, as long as the uses of the properties are alike.

Delayed exchanges are permitted.  There can be a delay between the sale of the old property and the purchase of the new property, but the proceeds from the first sale must be held by a third party who then uses them to purchase the new property.

Replacement property must be designated.  You must designate the replacement property within 45 days of the sale of the old property.  It must be done in writing to the third party qualified intermediary holding the proceeds from the sale of the old property.

Multiple replacement properties are OK.  The IRS allows you to designate up to three replacement properties so long as you eventually close on at least one of them.

Closing in six months.  You must close on the new property within 180 days following the sale of the old property, starting from the date the sale of the old property closes.

Cash is taxable.  Any leftover cash from the purchase of the new property will be taxed, usually as a capital gain.

Debt considerations.  Any mortgage or other debt on the old property, and any debt on the new property, must be considered in the transaction.  If your liability decreases, that will be treated as gain and will be taxed.

Names on both titles must be the same.  The name(s) listed on the title of the new property must be the same as the name(s) on the property that was sold.  There are workarounds for this in certain cases.

Our real estate attorneys represent parties on either side of real estate and financing transactions, including buyers, sellers, landlords, tenants, lenders, borrowers, trustees, guarantors, shareholders, partners, and others. We advise, structure, negotiate, and document a variety of real estate and financing transactions, including leases, purchase and sale agreements, financing agreements, and development agreements for a variety of commercial and residential projects. Contact us today and learn how we can help.

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