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Misconceptions Surrounding the 1031 Exchange

Posted on 5th Apr 2016

Section 1031 of the United States Internal Revenue Code (26 U.S.C. § 1031) allows for the exchange of certain types of property to defer taxes on capital gains for investment real property and personal property. Put another way, when real estate is sold, income taxes normally must be paid on the portion of the sale that is a profit, or gain. If, however, instead of selling the property, you exchange it for another investment or business property, then no capital gain will be attributed to the transaction. Therefore, no taxes are due. There are some misconceptions that many taxpayers have regarding 1031 Exchanges, clarified herein:

  • A 1031 Exchange simply defers taxes; it is not a loophole or tax avoidance mechanism, but instead is a planned tool to help promote the United States economy.
  • The term “property of like-kind” does not necessarily mean that the properties to be exchanged must be identical; just of the same value. The new property does not necessarily even have to be the same type of property as the one which is sold.
  • Through a 1031 Exchange, taxpayers may not only defer capital gains tax, but also depreciation recapture tax, state tax, and the investment income tax imposed by the Affordable Care Act.
  • If you want to completely defer payment of all capital gains taxes, then you must purchase new property of equal or greater value than the property being sold. If you purchase a property that is worth less than that which was sold, you can still defer a significant amount of taxes, but not all.
  • There are very strict time limits which must be followed when doing a 1031 Exchange. Once you sell what is called the “Relinquished” property, you have only 180 days to purchase a “Replacement” property. In addition, you have only the first 45 days in the 180 day period to identify the new property or properties that will be purchases.
  • Related parties may exchange property, but there ae specific rules which must be followed.
  • When participating in a 1031 Exchange, you are required to use the services of a qualified intermediary (QI), whose role is to provide guidance and documentation, as well as to secure your funds in between the sale and purchase of properties.
  • It is important to choose a qualified and competent QI, as they are not regulated by the federal government or by state law. It is important to make sure the QI you choose is financially stable and has insurance for errors and omissions.
  • There are also non-tax reasons to participate in a 1031 Exchange. For example, it can be a good estate planning tool to help consolidate or diversify a portfolio.

 

Before deciding to engage in a 1031 Exchange, you should seek advice from a financial planner or CPA, as well as a qualified 1031 Exchange tax attorney, to ensure that your actions match your tax and investment goals. Contact us today at (718) 347-6800.