What is a 1031 Exchange and Why is it Useful to Me?

A 1031 Exchange, also known as a Like-Kind Exchange, is an investment strategy utilized by owners of real property held for investment purposes.

The method gets its name from the Section of the Code of the Internal Revenue Service, and allows investors to sell a piece of property, take the proceeds from that sale, and purchase another piece of “like-kind” property. The primary benefit of this tactical decision is the deferral of capital gains.

For two properties to be deemed of “like-kind” they must be of the same nature or character. This does not mean that an owner of a hotel must exchange for another hotel. The hotel owner could sell the property and “exchange” it for a restaurant, a bowling alley, or any other type of real property. Typically, real property located within the United States can be exchanged for any other real property also located within the United States. The properties do not need to be alike in value, quality, or location.      

WHY

The advantage to the investor in executing a 1031 Exchange is the ability to defer capital gains related to the ownership of that property. By utilizing Section 1031, an investor carries over their basis in the original property, minus any money received by the investor (known as “boot”), plus any gain recognized on the transaction.

HOW

Although there are several logistical steps to be handled by your attorney, CPA, and others within the steps below, the following is an outline of a standard 1031 Exchange:

1. Sell the property. The exchange process cannot begin until the initial property has been sold.
2. Take the capital gains that would have been realized from the sale and escrow them with a qualified intermediary. The intermediary holds the capital gains until the new property is acquired.
3. Identify the replacement property (you can select multiple “target properties”) to be acquired within 45 of the initial sale.
4. Complete the transaction for the replacement property within 180 days of the sale. On the day of closing, the qualified intermediary sends the capital gains to the owner of the replacement property as payment. The investor may be required to put more money in if the replacement property is more expensive than the original property sold.
5. File the necessary IRS forms to show the transaction was done at arms-length and by the book. There may also be state forms that need to be completed, depending on where the properties are located and what state the investor lives in.

There has been much discussion of 1031 Exchanges in the context of individuals and families purchasing a second home. The IRS has firmly stated that properties purchased for personal use are to be excluded from the 1031 process and therefore don’t qualify for deferred gains. The IRS has issued a ruling that would allow a family’s second home to be covered – the ruling requires the owner to treat the property much like an investment property rather than a home for personal use.

If you think a 1031 Exchange might be right for you, or if you’d like to obtain more information in order to make that determination, contact Goosmann Law Firm’s offices in Sioux City, Sioux Falls, or Omaha so that we can assist you in effectuating your transaction.