If you are planning to sell your investment property, you may be able to defer the payment of capital gains tax under Section 1031 of the Internal Revenue Code. Section 1031 allows you to delay paying capital gains taxes on the sale of your property if you reinvest the sale proceeds in a “like-kind” (similar) property. Under this section of the regulations, you would only have to pay capital gains taxes if and when you sell the replacement property.
Before you decide to complete a Section 1031 exchange, however, you need to know the rules of how they work to ensure you’re able to defer the tax burden.
Eligible Types of Properties
Properties that qualify for Section 1031 transactions must either be investment or business properties. Your primary residence, vacation home, and personal use properties, then, do not qualify. To be considered “like-kind,” the property to be sold and the replacement property must also be comparable. So, real estate must be exchanged with real estate. All types of real estate are considered like-kind, so you can exchange a vacant lot for a duplex or single-family home, or vice versa.
Types of 1031 Transactions
There are several types of 1031 exchange transactions: simultaneous exchanges, deferred exchanges, and reverse exchanges. Simultaneous exchanges involve selling the first property and buying the second property concurrently. As one property is sold, the other must be purchased immediately under Section 1031 regulations.
Section 1031 exchanges typically require working with a qualified intermediary. An intermediary, also known as a facilitator, cannot be anyone involved in the transaction, including you or your real estate agent, attorney, or accountant.
Deferred property exchanges are the most common type of Section 1031 exchange. Deferred exchanges allow you to sell the first property and identify a replacement property within a 45-day period after the sale. Because of the time limitations, it is important to consider replacement investments before you sell the first property. The rules also mandate that you sell the first property before, or concurrently with, the purchase of the replacement property. You must deliver a form with the potential replacement properties in writing to the seller of the replacement properties or to your qualified intermediary.
In order to ensure that your transaction is eligible for the benefits of a Section 1031 exchange, a designated, qualified intermediary holds the funds of the sale of the first property until a replacement property is bought. The qualified intermediary will be in charge of the disposition of the first property and the acquisition of the second property, ensuring that the exchange occurs in compliance with current regulations. You need to use an intermediary to avoid receipt of the sale proceeds, which would make the transaction immediately subject to taxation. You must also acquire the replacement property and complete the 1031 exchange within the earlier of either 180 days of the initial sale or the due date of your income tax return for the year when you sold the property.
A reverse Section 1031 exchange involves the initial acquisition of the replacement property through your qualified intermediary. After this transaction, you have 180 days to dispose of the property you intended to sell in order to successfully complete the exchange.
The IRS website has more information about like-kind exchanges under Section 1031. For personalized advice, you should consult a legal professional who specializes in 1031 transactions.