A 1031 or tax-deferred exchange allows a property owner to sell one property and then go directly to buy another within a certain period of time. The name comes from the fact that the transaction is an exchange and not just an outright sale. In this process, the taxpayer is eligible for a deferred gain, since the IRS taxes property sales, but not 1031 exchanges. The IRS recognizes a 1031 exchange as a means of deferring capital gains taxes, so that it’s vital that you understand what’s involved, what the rules are, and what the underlying intent is before you can even think about doing one.
Any property owner purchasing a “like-kind” replacement piece of real estate should consider a 1031 exchange before selling the existing property. The sale of a property would incur a 15 percent capital gains tax at current rates, but this could go as high as 30 percent once federal and state taxes are factored in. By doing a 1031 exchange, you can circumnavigate this until such time as your property is sold for cash.
Equity real estate investment depreciates at 3 percent per year on the condition that you hold the investment until it has fully depreciated. When you sell the property, the IRS will tax the part that has been depreciated as income tax.
There are two basic rules that must be followed, along with other stipulations set forth by the IRS, for a 1031 exchange. The first rule is that the total price of the replacement “like-kind” real estate must be equal to or greater than the total price of the Total net sale of the property that was transferred. The second rule is that all of the equity that was acquired as a result of the sale of the relinquished property must be used to purchase the new “like-kind” property. If the value of the acquired property decreases, the tax will be applied on the difference.
Failure to follow any of these rules will result in tax liability for the person making the 1031 exchange. When the replacement property is of lesser value than the purchased property, the person will incur a tax liability. Also, if not all of the estate is transferred, the “like-kind” property tax rules will also apply. Partial exchanges can also be made, and these are generally eligible for a partial tax deferral as well.
Only a Qualified Intermediary (QI) can handle the proceeds from the sale of the original property, otherwise all proceeds will be deemed taxable. The entire amount acquired in the sale must be invested in the acquisition of the new property, and if any cash is withheld from the proceeds, it will be subject to tax. It is also important to note that this does not only apply to cash. Even if you do not physically receive the cash, but your liability on the acquired property decreases, you will still have to pay taxes.