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What is a 1031 Exchange? | monrovia homes for sale - monrovia real estate
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What is a 1031 Exchange?

Section 1031 of the Internal Revenue Code has been in existence since 1921, providing taxpayers with a mechanism to defer their capital gains tax when selling investment property and acquiring “like-kind” replacement property. Given the great reduction in available tax shelters over the years, this is one of the last great ways investors can minimize taxes while building their investment portfolios. That being said, investors must be mindful of the strict rules and timeframes contained in Section 1031 in order to effectuate a successful tax-deferred exchange.

First of all, the exchange must be set up prior to the close of the relinquished property. In order to accomplish this, the taxpayer will need to designate an Accommodator or Qualified Intermediary (“QI”). The QI will act as a third party to the transaction and participate only to facilitate the transfer of property without actually taking any interest in the property. When the relinquished property is sold, the QI will hold the proceeds from the sale on behalf of the taxpayer in a secure and separate interest-bearing account.

Once the relinquished property closes, the taxpayer has 45 days to identify like-kind replacement property(ies) and 180 days to acquire the replacement property(ies). (The 45 days is part of the 180 day period – you do not have 45 days plus an additional 180 days.) Day one is considered the next day after the relinquished property closes. There are no extensions or exceptions to these timeframes.

Once the taxpayer has the replacement property under contract, the QI will get assigned into the transaction. When the replacement property is ready to close, the QI will fund the transaction with the proceeds from the relinquished property and cause the replacement property to be conveyed to the taxpayer in order to complete the exchange.

Important Concepts:

  • To defer all capital gains tax, the taxpayer will need to find replacement property that has a value that is greater than or equal to in value of the relinquished property.
  • The taxpayer will be considered to be exchanging both the debt and equity associated with the property – not just the equity portion.
  • The taxpayer must acquire like-kind property – property that has the same character or nature.
  • It is important to clearly state your intent from the beginning to the end of the exchange transaction by adding the appropriate verbiage in the purchase and sale agreement (e.g., “Seller to cooperating with Buyer’s 1031 exchange.”)
  • If you are involved in a 1031 exchange, consult with your tax advisor for further information.

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