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What the 1031 Exchange means

Rathin Neogy, MBA

When a taxpayer sells income or investment properties and buys “like-kind” replacement properties, he uses what is called a 1031 exchange to defer paying income taxes on the capital gains. He can keep doing this and defer taxes indefinitely.

It is extremely important to understand the basics of the 1031 process to preserve wealth and assets. In the frequently changing world of taxation, an investor is able to use the 1031 to build wealth through real estate investment and maintain the hard-earned equity. This article deals with the essential things one needs to know about what a 1031 exchange means.

Using what is called a 1031 exchange; a taxpayer is able to sell income, investment or business property and replace it with “like-kind” property without having to pay Federal income taxes on the transaction.

Let us now discuss what is like-kind property: any property held for investment qualifies. This would include improved or unimproved real estate or income producing businesses. What would not qualify is the following: a personal residence, land being developed, speculation real estate purchased for resale, and common stock and bonds.

1031 Exchange Two parties, who are willing to exchange deeds of their investment property could perform a 1031 exchange among themselves. However, this is very rare, since typically the seller of the replacement property is not the buyer of the relinquished property. In general, a 1031 exchange is performed by knowledgeable and qualified intermediaries.

The general rules of a 1031 exchange are:

  • Relinquished property must be an investment property
  • The title to the replacement property must be taken in the same name or names as the title of the relinquished property
  • The replacement property must be like-kind
  • The value of the replacement property must be higher than the value of the relinquished property (if not, the taxpayer would have to pay capital gains taxes on the difference referred to as “boot received.”

Types of 1031 Exchange:

There are four types of exchange: (a) Simultaneous Exchange, (b) Delayed Exchange, (c) Reverse Ex-change and (d) Improvement Exchange.

(a) Simultaneous Exchange: It is an exchange in which the closing of the relinquished property and the replacement property occur on the same day — usually back-to-back. There is no interval of time between the two closings.

(b) Delayed Exchange: An exchange where the replacement property is closed on a later date than the closing of the relinquished property. The exchange is not simultaneous or on the same day. However, there are strict time rules to be followed. The taxpayer has to identify the replacement property within 45 days after selling the relinquished property and the replacement property has to be acquired within 180 days of selling the relinquished property.

(c) Reverse Exchange: Also called a Title-Holding Exchange, this is an exchange in which the replacement property is purchased and closed on before the relinquished property is sold. Usually the Intermediary takes title to the replacement property and holds title until the taxpayer can find a buyer for his relinquished property and close on the sale under an Exchange Agreement with the Intermediary.

(d) Improvement Exchange: Also called Title-Holding Exchange, it’s an exchange in which a taxpayer desires to acquire a property and arrange for construction of improvements on the property before it is received as replacement property. The improvements are usually a building on an unimproved lot, but also include enhancements made to an already improved property in order to create adequate value to close on the Exchange with no boot occurring.

Rules for like-kind property:

Finally, there are three basic rules regarding the acquisition of like-kind property in a 1031 exchange. These are the 3-property rule; the 200% rule and; the 95% rule. The 3-property rule simply means that you are limited to acquiring three properties in the exchange regardless of their market value.

The 200% rule means that you can acquire any number of like-kind properties as long as their aggregate value is no more than twice the value of the relinquished properties.

The 95% rule means that you can acquire any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate fair market value of all the potential replacement properties identified.

In conclusion, the 1031 exchange allows an investor to accumulate and continue to build wealth in a reverse-pyramid process as well as defer taxes indefinitely. Because of the complexities and rules of the 1031 exchange, it is always best to use a very experienced accountant as well as a knowledgeable and reputable intermediary to conduct the process.

Note: The opinions expressed in this article are those of the author and do not represent those of the Sterling Real Estate company.

The article is written by:

Rathin Neogy, MBA
The Sterling Real Estate Company

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