What Is An 1031 Exchange And How Does It Work?
Basically, a 1031 exchange is a tax-deferred exchange-in a typical transaction
, the property owner is taxed on any gain realized from the sale. However, through a Section 1031, the tax on the gain is deferred until some future date.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed; for example, vacant land swapped for an apartment building.
Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain. The like-kind transaction under Section 1031 is tax-deferred, not tax-free.
When the replacement property is ultimately sold, but not as part of another exchange, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
There are benefits to this kind of transaction, when it comes to exchanging vs. selling. Ultimately it will help you to postpone or potentially eliminate taxes due on the sale of qualifying properties.
When you defer these taxes, you will have more money to invest in other properties. You are receiving an interest free load from the federal government, in the amount that you would have paid in taxes.
Another benefit is that any gain from the depreciation recapture is postponed. You can also acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.
For these reasons, doing these kinds of property transactions is becoming increasingly popular. There are in all, five different kinds of swaps-it is important to know the difference between each of these so you can make the decision as to what will benefit you the most.
The first is simultaneous exchange. This occurs when the exchange of the relinquished property for the replacement property occurs at the same time.
A delayed exchange is the most common kind that is encountered. This happens when there is a time gap between the transfer of the relinquished property and the acquisition of the replacement property-this is subject to strict time limits, which are set forth in the treasury regulations.
The next is a build-to-suit deal. This technique allows the taxpayer to build on, or make improvement to, the replacement property, using the swap proceeds.
The fourth type, or Reverse, is a situation where the replacement property is acquired prior to transferring the relinquished property. The IRS has offered a safe harbor for reverse exchanges, as outlined in Rev. Proc. 2000-37, effective September 15, 2000.
These transactions are sometimes referred to as "parking arrangements" and may also be structured in ways which are outside the safe harbor.
The last kind is the personal property exchange. These are not limited to real property-personal can be exchanged for other personal property of like-kind or like-class.
Once the transaction is complete and the money is deposited into an exchange account, funds can only be withdrawn in accordance with the regulations. The taxpayer cannot receive any money until the exchange is complete.
If you want to receive a portion of the proceeds in cash, this must be done before the funds are deposited with the qualified Intermediary. This process can be a little complicated but is very doable.
To make sure you are making a valid exchange, you need to make sure that your type of property is not specifically excluded from the section 1031 treatment. There are exclusions, and to make sure that you don't run into any problems, double check where your property falls.
As you can see, 1031s can be a very profitable way to deal in property and make money. Make sure that you fully research the whole process, and feel comfortable before you begin.
by: Tommy Greene
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