1031 Exchanges - How to Defer Your Taxes on Your Real Estate Investments

The term 1031 exchange comes from the section number of the U.S. Internal Revenue Code and identifies special rules for like-kind exchanges in real estate. The code states you can defer the tax when you exchange a property used exclusively for business or as an investment property, for another property that is of the same type. Remember, the tax postpones and at the sale of the replacement property, adds to any taxable gain on that property. The government recognizes that when new property replaces a property sold and the seller reinvests the money, they never really take an economic gain.

There are many rules to follow to maintain the tax-deferred status in a 1031 exchange. The seller has to invest all monies into the next property or taxation occurs on the money received. The seller has to have equal or greater debt on the new property. If the new property has less debt, then the seller needs to produce extra cash from an outside sources and cover the difference in debt. The debt reduction is constructive receipt as though it is cash and there is tax on the difference.

The identification period occurs within 45 days after the close of the original property and requires the identification of a replacement property. The replacement property needs to close within the acquisition period, which is 180 days after escrow closed on the relinquishing property.

If the seller does not put all the money into the next property, that money receives taxation as boot and if the sale followed all other rules, the property still qualifies for partial tax deferral.

A reverse exchange also exists. This occurs when a taxpayer finds the perfect property before he sells the original property.

Properties do not have to cost the same amount or be in the same neighborhood to qualify as a like-kind exchange. Like-kind properties have the same nature or usage. Rental properties need replacement with rental properties.

There are many pitfalls for the average person to stumble into on a 1031 exchange, which is why a qualified intermediary is important for a 1031 transaction. The intermediary holds the funds in trust until the replacement property closing.

Tenants in common, also known as co-tenancy, is an increasingly popular method to purchase properties. This form of ownership assigns fractional ownership by the amount of money invested. The ownership of the property goes to heirs at the point of death, unlike joint owners with the rights of survivorship. The collective power of the group’s dollar makes the 1031 exchange easier and allows ownership in commercial and institutional property otherwise outside the financial abilities of the individual. Property managers normally handle the daily problems. If one tenant in common wants to sell, the other tenants in common have the option to vote to sell, not sell or buy the individuals shares. The same rules apply for tenants in common as apply to the individual.

A 1031 exchange is a particularly beneficial way for property owners to defer taxation and make the entire profit, not just the after tax profit, keep working for their benefit