A popular methodology of deferring taxable gain on the sale of business property is to use a 1031 exchange or like-kind exchange. The Internal Revenue Code 1031 is available to those who hold a property that qualifies as productive use in business or investments. If you are selling a piece of investment property, a 1031 exchange allows you to swap it for a similar property.
What is a 1031 exchange?
This type of exchange happens when an investor trades his or her real property for a similar or “like-kind” property. Investment properties such as commercial real estate or residential properties can be traded among themselves — like-kind merely refers to the type of investment and not the physical form. However, certain types of properties, such as those considered stock-in-trade, are excluded from 1031 exchanges.
Benefits of a 1031 exchange
The primary benefit of a 1031 exchange is that the investor can trade in their property and defer any capital gains due at the time of sale, as well as any capital gains taxes. There is also no limit on how many times you can exchange property. From an investor’s standpoint, this means that you can continue to make a profit on each additional swap, but you won’t pay any tax on it until you finally sell it off down the road. However, if an investor trades too many times in one year or tries to exchange a property right after it is purchased, their exchange request may be denied on grounds that they are functioning as a dealer.
Using like-kind exchanges as an estate planning tool
Taxpayers who complete a 1031 exchange without paying capital-gains taxes who then pass away, can avoid taxes altogether, since their heirs will inherit that property with a stepped-up basis equal to the value of the property at the time of death.
What are the deadlines?
Once the sale closes on your first property, your facilitator will receive the cash from the sale and you must submit, in writing, the property you are exchanging it for to your facilitator within 45 days. You then have 180 days, starting on the day of sale of your first property, to close on the second.
Choosing a Qualified Intermediary
You must use a qualified intermediary (QI) to facilitate a 1031 exchange. The QI will:
- Prepare the legal agreements to properly structure the 1031 exchange.
- Hold and safeguard the funds from the sale of the original property until a new property is purchased.
- Ensure the exchange complies with IRS rules.
These are just the basics; there are a lot of details and exceptions in the fine print of the tax code. If you are planning to sell an investment property and feel you might be eligible for a 1031 exchange, please reach out to your LMC professional.