Rollover Your Profits to Defer Capital Gains Taxes - Seems Easy Enough Right?
Section 1031 of the United States Internal Revenue Code (26 U.S.C § 1031) states "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."
This allows real estate investors to exchange one investment for another similar property, and the gains are rolled over into the new property. Doing this allows investors to defer capital gains taxes as well as depreciation recapture taxes that would occur with their sale.
These taxes can eat up to 40% of real estate profits, so this means big savings. Plus there is no limit on how many times you can use a 1031. There isn't a catch here, but there are very finite rules you have to follow to take advantage of the savings.
HOW A 1031 EXCHANGE WORKS
Also referred to as a like-kind exchange, investors swap one income-producing asset for another. They sell one property and use the cash earned from the sale to purchase another without having to pay taxes on the money earned from the sale.
Smart real estate investors take advantage of this technique to continue rolling their investments and keep their business growing.
It sounds simple and easy, but like everything in tax law, there are a few rules and red tape to contend with. However, as long as the funds continue to be reinvested in like-kind property and you follow the rules, your capital gains tax can be deferred.
So what are the rules?
- Like-kind means the old property, which is referred to as the relinquished property, and the new property, called the replacement property, must be of the same nature, character, and use.
- There are two main rules regarding the like-kind property for a 1031 Exchange.
- The total price of the new replacement property must be equal or greater than the net sales price of the old relinquished property.
- All equity from the sale of the relinquished property must be used to acquire the replacement.
TIME LIMITATIONS ON A 1031 EXCHANGE
A like-kind exchange comes with two time restrictions. The limits will not be extended and going past them will cost you the savings of the deferred capital gains tax.
IDENTIFICATION PERIOD - 45 DAY LIMIT
Investors have 45 days from the sale date of the relinquished property to identify the replacement property or properties. For this identification period, a clearly described written identification of the property is required.
EXCHANGE PERIOD - 180 DAY LIMIT
The second time limitation to be aware of is the exchange period. The replacement property must be acquired no later than 180 days after the sale of the original property. It's very important to note that the two time limits can't be used separately to equal 225 days, and the total amount of time that is allotted is 180 days.
1031 transactions, starting with the sale of the relinquished property, must go through the hands of a qualified, third-party intermediary.
To qualify as a Section 1031 Exchange, a deferred exchange must be distinguished from a taxpayer simply selling one property and using the proceeds to buy another. The intermediary holds profits from the sale and disburse those funds at the closing of the exchanged property. The taxpayer never has what the IRS considers “constructive receipt” of funds. They are rolled over directly into the new property, thus creating no gains, thus no gains to tax.
WARNINGS ABOUT 1031 ROLLOVERS
Failure to comply with the deadlines and all the rules will result in a failed exchange. If cash or other proceeds are used before the exchange is complete, the entire transaction is disqualified, and all gain is immediately taxable. You might even be held liable for penalties and interest on your transactions.
HIRING HELP FOR A 1031 EXCHANGE
While it might seem like a fairly straightforward process, this assumption is dangerous. There are many nuances, detailed rules and laws governing the 1031 Exchange rule. Investors who use the 1031 Exchange program almost always consult with a highly trained professional who is well-versed and experienced in 1031 tax deferred exchanges. We recommend you do the same and then reach out to our investor sales team to help identify the best property that will fit your 1031 Exchange plans.
Want to learn more? Book a meeting here with our investor sales specialist.