For the real estate investor selling a property, understanding and implementing US Code §1031 is a savvy strategy to defer capital gains taxes and free up investment dollars for a replacement property.
What is USC §1031?
Investors selling real estate are subject to either short-term capital gains tax (up to 37%) or long-term capital gains tax (up to 20%). Using the provisions enumerated in Section 1031, investors can defer capital gains by purchasing a replacement property of the same nature, character, and class (according to the IRS). To receive full investment benefit, the replacement property should be equal or greater value. Known as 1031 Exchanges, there are three types:
Simultaneous 1031 Exchange
The closing sale of the relinquishing and replacement property occur on the same day. It can be a swap of one property for another, or a simultaneous exchange through a qualified intermediary.
Deferred 1031 Exchange
Allows the sale of property and subsequently the acquisition of one or more other like-kind replacement properties. Proceeds from the sale must be transferred to a qualified intermediary, and there are time limits to completing a deferred exchange from the date a property is sold: 45 days to identify potential replacement properties, and 180 days to complete the exchange.
Reverse 1031 Exchange
Provides an investor a chance to purchase a replacement property before selling the original. The replacement property sale is placed into an exchange accommodation titleholder, and the investor has 180 days to sell the original property.
All 1031 exchanges must be included in annual tax filings on IRS form 8824 Like-Kind Exchanges. Not following the rules for like-kind exchanges can result in tax liability, penalties, and interest on transactions. Real estate investors should always consult a tax professional prior to utilizing the 1031 Exchange option.
The ability to free up substantial investment capital to reinvest in property acquisition seems too good to be true for real estate investors. However, following the rules outlined in USC Section 1031, capital gains tax deferral through the exchange process is a proven and savvy real estate investment strategy.
