Who Should Understand the 1031 Tax Deferred Exchange?
Investors who either flip properties or who decide to sell one or more of their current rental properties to invest in new ones should understand the 1031 Exchange rule. It is also known as a Starker Exchange or a Tax Deferred Exchange.
What is a 1031 Exchange?
It is a transaction covered by Section 1031 of the IRS Tax Code. It allows real estate investors to “exchange” (buy and sell) real estate without paying out capital gains tax (CGT) on the sale. The CGT is used to purchase the new property or properties. The CGT only becomes payable if a property is then sold without the proceeds being reinvested or is invested in a non-qualifying purchase.
Can Any Property Be “Exchanged” to defer CGT?
No. The transactions must all fall within parameters set out in the Tax Code and the approved steps must be followed. By working with a title agent or real estate attorney who is approved to handle 1031 Exchanges, known as a Qualified Intermediary (QI), the process becomes straightforward.
How Does a 1031 Exchange Work?
Like this:
- All properties must be in the USA or an American Territory.
- The purchased property(ies) must be of an equal or greater value than the sold property(ies).
- All properties must be what the IRS calls “like-kind.” They must all be either raw land or improved real estate. Zoning and types (residential, commercial, industrial) are unimportant. So, for example, an investor can sell commercially-zoned raw land and buy a multi-family residential building. What matters is all properties must be for investment or business purposes.
- Since the 2017 Tax Cuts and Jobs Act, equipment, trucks, patents, etc. sold or bought with the real estate are no longer considered “like-kind.”
- The term “sell” is replaced with “relinquish” and “buy” becomes “acquire.” The QI will only use those terms on official paperwork.
- When one or more properties are relinquished, the QI holds the proceeds in an approved account. If it is released to the seller, the IRS considers it a regular sale and any CGT becomes due. When the acquired properties change hands, the QI releases those proceeds to complete the transaction. Technically, therefore, properties were exchanged and not bought and sold.
- There are time limits on a 1031 Exchange which must be adhered to. Properties must be exchanged within a total time frame of 180 days.
- In a “reverse exchange” new properties may be acquired before current properties are relinquished. We do not have the space to go into those details here, but a QI or an experienced Realtor will explain them.
Final Comment
When investors understand the 1031 Exchange process, they defer CGT giving them more liquid capital to reinvest. The 180 day flexibility built into the process enables investors to complete either side of the transaction to suit their own plans or the market cycle.