Internal Revenue Code Section 1031 allows owners of real estate investment property to sell their property and purchase new property with the proceeds of the sale while deferring the taxes which would ordinarily be due as a result of the capital gain realized on the sale. This is commonly known as a “1031 Tax Deferred Exchange”, or a “Like-Kind Exchange”. There are very specific rules which must be strictly adhered to for this vehicle to be successfully employed. However, if properly handled, the 1031 exchange can allow investors to legally defer the payment of capital gains taxes which would ordinarily be due on the profits realized from the sale.
The real property must be exchanged with “like-kind” real property. This term is very broadly defined by the I.R.S. and essentially means that all real estate is considered to be “like-kind” with other real estate provided that the property is not owner occupied and is not held primarily for sale. Therefore, personal use of property as a second home does not qualify, nor does the sale of your primary residence.
Furthermore, there is a very strictly enforced deadline of forty-five days from the date of the closing on the property being sold to identify the replacement property that you intend to purchase. You must then close on the property to be acquired within 180 days of the closing on the relinquished property, or due date of the property owner’s tax return for the year in which the transfer of the relinquished property occurred, whichever occurs first. There are absolutely no extensions of this period for any reason whatsoever.
The seller cannot receive any of the funds from the sale. The proceeds go to a “Qualified Intermediary” who parks your money for you as a “safe harbor” until you are ready to purchase the replacement property. There are several companies which facilitate the “like-kind exchanges” and will work with you to coordinate the transaction. These companies serve as “Qualified Intermediaries”.
If you are considering the use of a 1031 Exchange, you need to discuss the benefits of doing so with your accountant or financial adviser before making a decision as to whether a 1031 exchange is right for you. In addition, it is imperative that you advise your attorney at the time that the Contract of Sale is entered into that you might be using the 1031 Exchange, because specific language must be added to the Contract of Sale to facilitate the exchange.