What is a 1031 Exchange?

A 1031 exchange is an excellent tool available to owners of investment real estate. Section 1031 of the Internal Revenue Code states, in effect, that upon the sale of an investment property or real property used in a trade or business, the owner can use the funds from the sold property to purchase a similar, or "like-kind" property, and thus not be liable for capital gains taxes on the proceeds from the initial property. To complete a 1031 exchange, there are some basic rules that must be followed.

The "like-kind" property must be identified within 45 days of the closing on the initial property. All proceeds from the initial sale must be turned over to a "qualified intermediary" (QI), who is the person or company that essentially plays the role of the middleman. Any of the proceeds not under the control of the QI, are subject to taxation. The QI will hold the funds from the initial property in escrow until such time the closing on the second property occurs. The QI will also assist the owner with the preparation of paperwork and other services to ensure the transaction progresses smoothly. Additional 1031 exchange rules require that the new property acquired by the investor much carry the same or greater debt than the initial property, and that the closing on the second property takes place within 180 days following the close on the first property.

In a hypothetical situation where a real estate owner sells a retail store for $500,000.00 with a net profit of $220,000.00, a sizeable capital gains tax would be paid to the IRS. If however, the owner finds a new real estate investment and meets the 1031 rules outlined above, the owner can defer the capital gains taxes on that property.

Some individuals are uncertain what the term "like-kind" means. In short, a like-kind property has been given a very generous interpretation by the IRS. For instance, it does not mean that an investor who sells unimproved land must exchange the property for another piece of unimproved land. Rather, the seller of the unimproved land merely needs to invest in another investment property and follow the 1031 rules while doing so.