There are many benefits to deferring taxes owed from capital gains with a 1031 exchange, but the process is very specific, so it is suggested that investors consult competent tax professional and a qualified intermediary prior to closing on a relinquished property to determine potential tax liability and merits of utilizing a Section 1031 tax-deferred exchange.
What is a 1031 Exchange?
For those of you who are not familiar with Section 1031 exchanges (aka “like-kind” exchanges) the basic definition is as follows: A method of selling business or investment property but deferring payment of capital gains taxes by reinvesting the proceeds of the sale in another business or investment property.
IRS Section 1031: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”
The typical steps of a 1031 exchange are as follows:
- Include a standard “cooperation clause” language into your sales contract
- Contract with a qualified intermediary to handle your sale proceeds
- Close on your relinquished property
- Title company send all sale proceeds to you qualified intermediary(QI) to be held in escrow
- Identify potential replacement properties with your QI within 45 days of closing on the property you sold (also known as you “relinquished property”)
- Contract purchase(s) of replacement properties requiring an equal or greater amount of equity and debt as was on your relinquished property
- Close on your replacement property/properties within 180 days of the closing of your relinquished property
- Have proceeds for replacement property closing transferred from your QI for settlement(s)
- Complete Form 8824 with your federal tax return to report your executed exchange to the IRS when filing taxes for that calendar year