The 1031 Exchange: i.e. Tax Deferred Real Estate Business Investment
Under 26 U.S.C. 1031, “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” So, in the real estate world, what does this exactly mean?
In a nutshell, a 1031 exchange provides an exception that allows you to postpone paying taxes on a gain recognized in the exchange of business or investment property as long as the proceeds of such exchange are reinvested in similar property in the form of a like-kind exchange. Nevertheless, such exchanges are subject to several restrictions that must be met in order for taxes to be deferred.
First, the exchange must involve qualifying property. In essence, both properties involved must be:
- Held for use in trade or business or for investment; and
- Similar enough that they classify as “like-kind” property.
When considering whether the property classifies as “like-kind,” it is important to note that most real estate will classify and that quality and grade are not considered. For example, real property that is improved with a residential rental house is “like-kind” to vacant land.
However, certain property will not qualify for the 1031 exchange. One type of property that will not be considered are improvements that are conveyed in the absence of land. Furthermore, if a property is located outside of the United States, it will not be considered “like-kind” property regardless of how similar the property is to that of the domestic property being considered. And finally real property can never be “like-kind” to personal property.
Second, though the exchange does not have to be simultaneous, the exchange must fall within the two following applicable time limits that the 1031 exchange is subject to:
- Substantial identification of the replacement property for that property being sold within forty-five (45) days from the date you relinquish the property sold; and
- Receipt of the replacement property within one hundred eighty (180) days from the date of relinquishment or the due date of the income tax return for the year the relinquished property was sold.
It is also important to note that the replacement property actually received must be substantially the same as the property identified within the 45-day time limit.
So, if both of these requirements are met and your exchange falls within a 1031 exchange, you may avoid tax liability on the property until such property is sold for cash. There are no limitations established for how many times one can do a 1031, thus you may exchange property after property and only pay one tax at a long-term capital gain rate (currently 15 – 20%).
To specifically walk through the process, we will use the previously stated example of the swap of immovable property improved with a residential rental house for vacant land. A seller sells the immovable property improved with a residential rental house (property held for business or investment) for $300,000. The existing loan on the immovable property is $100,000 and the exchange expenses were $25,000. Thus, the net proceeds of the sale are equal to $175,000. From here, in order to meet the requirements for a 1031 exchange, the seller must identify the vacant land (to be held for business or investment purposes) to be purchased with the net proceeds of his sale within forty-five days of such sale and actually purchase that identified vacant land within one hundred and eighty days from the sale. Furthermore, the entirety of the $175,000 from the previous sale must be used for the down payment of the vacant land. If that $175,000 is not used in its entirety, the cash left over will be taxed. If the $175,000 is used in its entirety, the buyer will not be taxed on the sale until a cash profit is recognized.
Under 26 U.S.C. 1031, “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” So, in the real estate world, what does this exactly mean?
In a nutshell, a 1031 exchange provides an exception that allows you to postpone paying taxes on a gain recognized in the exchange of business or investment property as long as the proceeds of such exchange are reinvested in similar property in the form of a like-kind exchange. Nevertheless, such exchanges are subject to several restrictions that must be met in order for taxes to be deferred.
First, the exchange must involve qualifying property. In essence, both properties involved must be:
- Held for use in trade or business or for investment; and
- Similar enough that they classify as “like-kind” property.
When considering whether the property classifies as “like-kind,” it is important to note that most real estate will classify and that quality and grade are not considered. For example, real property that is improved with a residential rental house is “like-kind” to vacant land.
However, certain property will not qualify for the 1031 exchange. One type of property that will not be considered are improvements that are conveyed in the absence of land. Furthermore, if a property is located outside of the United States, it will not be considered “like-kind” property regardless of how similar the property is to that of the domestic property being considered. And finally real property can never be “like-kind” to personal property.
Second, though the exchange does not have to be simultaneous, the exchange must fall within the two following applicable time limits that the 1031 exchange is subject to:
- Substantial identification of the replacement property for that property being sold within forty-five (45) days from the date you relinquish the property sold; and
- Receipt of the replacement property within one hundred eighty (180) days from the date of relinquishment or the due date of the income tax return for the year the relinquished property was sold.
It is also important to note that the replacement property actually received must be substantially the same as the property identified within the 45-day time limit.
So, if both of these requirements are met and your exchange falls within a 1031 exchange, you may avoid tax liability on the property until such property is sold for cash. There are no limitations established for how many times one can do a 1031, thus you may exchange property after property and only pay one tax at a long-term capital gain rate (currently 15 – 20%).
To specifically walk through the process, we will use the previously stated example of the swap of immovable property improved with a residential rental house for vacant land. A seller sells the immovable property improved with a residential rental house (property held for business or investment) for $300,000. The existing loan on the immovable property is $100,000 and the exchange expenses were $25,000. Thus, the net proceeds of the sale are equal to $175,000. From here, in order to meet the requirements for a 1031 exchange, the seller must identify the vacant land (to be held for business or investment purposes) to be purchased with the net proceeds of his sale within forty-five days of such sale and actually purchase that identified vacant land within one hundred and eighty days from the sale. Furthermore, the entirety of the $175,000 from the previous sale must be used for the down payment of the vacant land. If that $175,000 is not used in its entirety, the cash left over will be taxed. If the $175,000 is used in its entirety, the buyer will not be taxed on the sale until a cash profit is recognized.
