A 1031 Exchange is a powerful tax-deferment strategy used by some of the most financially successful investors to defer taxes when selling investment/commercial property. This effective strategy is also known as a “Starker Exchange”, named for the first tax case that allowed the exchange, or a “Like Kind Exchange”, referring to the type of change that occurs. This tax-efficient way of preserving capital that is invested in real estate is appropriately named a 1031 Exchange, after Section 1031 of the IRS code.
Section 1031 of the Internal Revenue Code provides an exception that allows the deferment of payments of capital gains taxes when a business or investment property is sold, if the reinvestment of the proceeds is reinvested in a similar property through a like-kind exchange. To put it simply, a 1031 exchange allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long another “like-kind property” is purchased with the profit gained by the sale of the first property. An investor will eventually cash out and pay taxes, but in the meantime, Section 1031 allows an investor to trade properties without incurring a sudden tax obligation.
Like-Kind property is a very broad term which means that both the original and replacement properties must be of “the same nature or character, even if they differ in grade or quality.” In other words, the exchanged wouldn’t work when changing farming equipment for a fitness center, because they’re not the same character. Here are some examples of acceptable exchanges that are considered to be like-kind: Residential to commercial, industrial to raw land, single family to multifamily. They also allow a two for one deal (or vice versa), the number of properties does not matter. It is possible to sell one and buy two or sell two and buy one. What is important, the 1031 Exchange Rules require that both the purchase price and the new loan amount be the same or higher on the replacement property.
The exchange can occur simultaneously or delayed for a maximum of 180 days. The likelihood that the owners of the two swap properties want each other’s property is incredibly unlikely. Therefore, the rules allow a delayed exchange to make the transaction successful. In a delayed exchange, there is a middleman who holds the cash after the sale of the property and uses it to “buy” the replacement property to complete the transaction.
Those who hold real estate inventory, or who purchase real estate for re-sale, are called "dealers". These properties are not eligible for Section 1031, unless they are also an investor and meet the same requirements for exchange. It is important to note, personal use property does not qualify for Section 1031, only commercial investments.
The like-kind exchange technique is fundamental to the real estate investment sector. The current law provides real estate investors with a sizeable amount of flexibility in managing their real estate portfolio. A common mistake that investors make is not seeking the advice from legal, tax, and financial advisors. They also need to locate a good qualified intermediary. Knowledge is key. Unfortunately, investors are not typically “experts” in the process, and may be sadly unaware when they have a potential problem with their 1031 exchange transaction if they don’t enlist the help of a knowledgeable professional.