For real estate investors, the 1031 exchange is a powerful tool for managing tax liability when selling and purchasing investment properties.
Normally, when property is sold, any gain on the sale will be taxed. However, the 1031 exchange allows an investor to defer capital gains tax on the sale of a business or investment asset when the investor uses the proceeds to purchase an asset of like-kind. This is extremely beneficial to investors as it provides them with more capital to invest in their subsequent purchase. Although the 1031 exchange can be used in a variety of different ways, it is most commonly associated with real estate transactions.
In order to engage in a 1031 exchange, the property must be a business or investment asset, meaning the property generates revenue or helps in generating revenue. Typically, these properties will be warehouses, offices or rental homes. Primary residences and other property that do not generate regular income do not qualify, such as a second home or vacation home. Further, the property exchanged must be of like-kind, meaning that the swapped properties are of a similar nature. With real estate transactions, like-kind is interpreted liberally as most real estate will be like-kind to other real estate. For instance, real property with a structure on it will generally be considered like-kind to vacant land and vice-versa.
The timing of a 1031 exchange is extremely important. First, the investor needs to hire a qualified intermediary before they close on their sale because the funds cannot be held by the investor and must be held in a trust for the subsequent purchase. Most often, the qualified intermediary will be a bank, title company or attorney. Second, the investor must identify in writing a designated replacement property within 45 days of the closing on the sale. Generally, an investor may identify up to three properties that may serve as the replacement property, and at least one of these properties must eventually be acquired as the replacement property. In some instances, an investor can identify more than three replacement properties so long as either (i) the fair market value of all the identified replacement properties does not exceed 200% of the value of the sold property or (ii) the investor purchases at least 95% of all identified replacement properties. Third, the investor must close on the designated replacement property within 180 days of the closing on the sold property. For this reason, it is recommended that an investor that wants to engage in a 1031 exchange be in contract for the purchase of the replacement property near the time of closing on the sold property.
It should be noted that if there are any gains realized in the exchange, the gains will be taxed. For example, if the sale proceeds on the sold property are greater than the cost of the replacement property, then the investor will be taxed on the difference. Further, where the properties are financed, if an investor’s mortgage liability is reduced by the exchange, this would also be considered a gain and thus taxed. Alternatively, if there is a loss in the exchange, an investor can choose to defer the loss under the 1031 regime, although this is in most instances unadvisable.
For owners of business or investment property, the 1031 exchange provides an amazing opportunity to upgrade assets with minimal tax consequences. Although a 1031 exchange does require planning and adherence to a strict protocol, it should always be considered when an investor or business is looking to simultaneously buy and sell assets.
For more information on 1031 exchanges or real estate law generally, please contact the NYC real estate attorneys at the Kanen Law Firm.