Understanding 1031 Property Exchanges
The Internal Revenue Code, Section 1031 enables individuals to conduct tax-deferred exchanges of like-kind property. But how exactly this works and the tax consequences depend on the details and circumstances of the exact exchange. A simple swap, such as one piece of commercial real estate for another, allows a taxpayer to defer paying taxes on capital gains. But many 1031 exchanges are not so simple. A taxpayer could end up with a tax liability based on gains from the exchange. If you are considering a 1031 property exchange for your business or investments, review the basics of this option and contact an experienced West Palm Beach business transactions attorney right away.
Properties that Qualify for Like-Kind Exchanges
In order for the 1031 exchange to apply, both the sold and replacement property must meet specific criteria, including:
- Held for use in trade or business, or as an investment;
- Either both real property or both personal property; and
- Similar to one another in nature, character, or class.
Properties that specifically do not qualify for like-kind exchanges include:
- Personal residences;
- Second or vacation homes;
- Stocks, bonds, notes, or other securities;
- Certificates of trust; and
- Partnership interests.
What it Means to be Like-Kind Properties
Most real estate will be considered like-kind to other real estate properties. The quality or improvements upon the land will not affect being like-kind to other land. However, there are limitations to this assumption. Real estate in the U.S. will not be like-kind to real estate outside of the U.S.
Being of like-kind is different for personal property. The law looks for more specificity in similarity between properties. A car could be exchanged for a similar car but not for a valuable painting.
It is important to note that you do not have to swap one property for another other property. Your sold property may be replaced with multiple smaller properties or you may exchange a number of properties for one larger asset.
While it is possible that your business could exchange one piece of property for another immediately, most 1031 exchanges are known as delayed because the it is difficult to find a piece of property you want from a business who wants the property you have to exchange. To deal with this situation, many people sell a piece of property and have a third party hold the money. This money is then used to purchase the replacement property within 45 days. For a delayed 1031 exchange to work, you can never receive the money from the sale of your property and you must designate a replacement property in writing to the third party within 45 days of the sale of your property.
There is another important timing issue with delayed exchanges. You must close on the replacement property within 180 days of the sale of your old asset.
There May be Gains After the Exchange
There are many ways in which there could be taxable gains during a 1031 exchange. There may be cash you receive from the third party after it purchases the replacement property. Any cash you receive is taxed as partial sales proceeds.
You may also experience a gain if your liability due to the property decreases. If the mortgage or debt owed on the replacement property is less than the mortgage or debt owed on the sold property, your liabilities decreased and this gain can be taxed.
Contact The Law Offices of Larry E. Bray, P.A. For Help
This information is only the tip of the iceberg when it comes to understanding 1031 exchanges. This type of tax benefit can be beneficial for your business, but only if it is used correctly. Call attorney Larry E. Bray in West Palm Beach to learn more about this option including whether the property you want to sell may qualify and how you will need to structure the contracts for the exchange.