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Section 1031 Tax Free Exchanges of Real Property

What is a IRS Section 1031 Tax Free Exchange?

What does it mean when your Chicago business lawyer advises you to "1031 that building for another"?

Simply put, your lawyer wants to help you make your real property transaction non-taxable. Section 1031 of the Internal Revenue Code (26 U.S.C. § 1031) is designed to help real estate investors, or any commercial property owners, to shift their focus on their trade without incurring the tax liability. A Section 1031 Exchange, also known as a "like kind exchange" or a "Starker exchange", is a tax-deferment strategy that allows a property owner to defer paying capital gains taxes on real property when it is sold, as long as the profit from this sale is used to purchase another "like kind property." Investors can trade properties with no obligation to pay taxes on the sale until the investor cashes out and realizes the capital gain. This tax benefit currently translates into immediate cash savings of to 20% of the value of the property.

What Property Qualifies for a "Like Kind" Exchange?

Previously, section 1031 applied to a wide array of property. The Tax Cuts and Jobs Act of 2017, however, amended the rule to apply to real property only. Thus, effective January 1, 2018, the exchanges of personal or tangible property, such as machinery, equipment, intellectual property, or security instruments, are not eligible for tax deferment under this section.

What is "Like Kind" Property?

The statute specifies that the property to be exchanged must be of "like kind", and to be held either for "either for productive use in a trade or business or as an investment". (26 U.S.C. § 1031(1)) Most real estate properties located within the United States are considered to be "like kind", whether improved or unimproved (land). Note, however, that both the original and the replacement property must be located within the United States - a foreign real estate does not qualify as a like kind exchange under this section.

Exchanges can include more than two properties. For example, an owner may exchange multiple properties for one bigger property, and vice versa.

In addition, the property to be exchanged must be held for investment or business use. Therefore, a real estate held as an inventory or purely for a re-sale purpose does not qualify for capital gains tax deferment under this rule. If the purchase and sale of real property is conducted in the ordinary course of business, any gain or loss from those sales is considered ordinary income, not capital gain.

Another exception to this rule is transactions involving primary residence. Unfortunately, you can't swap one primary residence for another and defer capital gains tax under this rule.

Examples:

  • An individual who moved from Illinois to Wisconsin could not exchange her primary residence in Illinois for another primary residence in Wisconsin.
  • An individual who gets married and moves into her spouse's home, could not exchange her former primary residence for a vacation home.
  • A single-family rental property in Chicago may be exchanged for a commercial rental property in New York.
  • A rental property in El Paso could not be exchanged for a rental property in Tijuana, in spite of the geographical proximity.
  • A building used for commercial purposes in Chicago may be exchanged for two single-family rental homes in Chicago.
What are the Types of Exchanges?

There are four main types of like kind exchanges: simultaneous, delayed, reverse, and construction. The most common type is the delayed exchange. This type of exchanges involves three parties and gives the seller some flexibility in finding the right property to purchase. It occurs when the seller relinquishes the original property before she acquires replacement property. In order to begin this transaction, the seller must hire a Qualified Exchange Intermediary (middleman) that will initiate the sale of the property and hold the proceeds from this sale in a binding trust for up to 180 days while the seller acquires another property. A business lawyer may act as your Exchange Intermediary.

Is There a Property Value Requirement?

In order to completely avoid the immediate payment of taxes upon the sale of the property, the net market value and the equity of the replacement (purchased) property must the same as, or greater than, the relinquished (sold) property.

Example: The original property is a commercial building with a value of $1,000,000, and a mortgage of $800,000. In order to qualify for a full benefit of section 1031, the new real estate purchase must have a value of at least $1,000,000, and carry at least $800,000 in mortgage. As mentioned before, the new purchase may consist of one or multiple buildings, with a combined value of $1,000,000.

Note that acquisition costs, such as broker or closing fees, also apply toward the total cost of the new property.

If the value of the replacement property is less than that of the original property, the owner may still carry out a partial 1031 exchange. In this case, however, the owner will be liable for the tax on the capital gain realized on the exchange. This gain is known as "boot".

Example: The original property is a commercial building is sold for $1,000,000. The replacement one-family rental home is purchased for $800,000. The owner would be liable for normal capital gains tax on the $200,000 "boot".

What is the Timing Requirement?

The property owner must identify up to three potential like kind replacement properties within 45 calendar days of the closing of the relinquished property. The replacement property, however, need not be under contract within the 45-day period. From that point, the owner has another 135 days to actually acquire the new property. Overall, replacement property must be acquired within 180 days of closing on the relinquished property, OR the due date of the income tax return (with extensions, if any) for the tax year in which the relinquished property was sold, whichever is earlier.

The IRS does not impose a limit on how many times or how frequently you can conduct a 1031 exchange. Invoking this rule allows your investments to grow tax deferred.

Consult With Experience Business Lawyers

Consult a Chicago business lawyer to make the most out of your real estate transactions. For more information contact the experienced Chicago business lawyers like the lawyers of Bellas & Wachowski. Call Makedonka Baloski for more information on tax free exchanges as well as other estate planning advice.