The Internal Revenue Code Section 1031 Tax Deferred Exchange allows investors to sell income or investment real estate and buy another of like kind in order to defer all state and federal taxes on capital gain. The definition of 'like kind' is broad and includes any real estate held for investment purposes, including commercial real estate, rental property, bare land, etc.. Therefore, improved investment real estate may be exchanged for unimproved investment real estate, a rental home for a commercial property or any number of other such combinations. It is very important to note that sale of a primary residence will not qualify for a 1031 exchange.
The advantage of this tax postponement is obvious. The investor can reinvest his or her full capital into new properties without any reduction due to tax payments. The government, in effect, extends an interest-free loan to the investor, who then is able to obtain leverage over and above that obtained from regular mortgage financing.
The ground rules are simple and structuring your sale as an exchange can be easy, fast and inexpensive. In fact, a good third party intermediary (facilitator or accommodator as they are often called) and a qualified real estate agent will guide you through the entire process as long as you inform them before closing of escrow that you intend to "exchange". A good intermediary will insure that you follow the few strict rules of the Internal Revenue Code:
- One party must agree to cooperate and sign a novation, a document which outlines the intention to "exchange" rather than sell, at no additional expense or liability to the other party.
- An exchangor has up to 45 calendar days from the close of escrow on the relinquished property to identify in writing to the intermediary up to 3 replacement properties. If the exchangor wishes to identify more than three properties, special rules apply and your intermediary will provide the details of these requirements.
- Once the 45 day period has lapsed, the exchangor has up to 135 days to close on all replacement properties. Therefore, there is a total of 180 days to complete the entire 1031 Exchange transaction. (If you plan to close a sale of investment property after October 15, you will need to file an extension on your taxes in order to have the full 180 days to complete the exchange because of the April 15 tax deadline. Plan ahead.)
- A Reverse Exchange is possible and allows the exchangor to purchase the replacement property(ies) before selling the investment property currently owned. The intermediary will acquire title to the new property and essentially hold on to that property until the exchangor is ready to close on the sale of the old property. Talk to your intermediary for all of the details.
