Most real estate investors understand the general concept of a 1031 exchange or, at the very least, have heard of it. Few, however, understand exactly what takes place within one of these exchanges and how powerful a tool it truly is. So let’s explore a subject that is close to everyone’s heart: not paying taxes on hard-earned money!
What’s in it for Uncle Sam?
So, why does the IRS Section 1031 like-kind tax-deferred exchange exist in the first place? After all, doesn’t the government relish every taxable opportunity? While the government is certainly not adverse to taxation, they also use the tax code as a tool, encouraging or discouraging certain acts they deem beneficial or detrimental to the economy. As it turns out, the private sector is pretty darn good at providing housing to society (a lot better than the government). As such, Uncle Sam provides various benefits to real property owners (mortgage interest deductions, real estate investment expense deductions, ability to depreciate, etc.).
The Like-Kind Exchange: Apples for Apples?
To go along with this philosophy, the IRS allows real estate investors to defer the capital gains resulting from the sale of their property as long as they identify and purchase “like-kind” property within specified time frames.
So, what is “like-kind” property?
Basically, it is any real property held for a specific use. Hence, vacant land held for investment purposes (the government doesn’t say it has to be a good investment) can be exchanged for a residential income property. In other words, trading investment property for other investment property is allowed. One wouldn’t be allowed to, however, exchange a residential rental property for a brand new single family home in which the investor plans to take residence. You can find the exact IRS verbiage on the IRS Website.
Time is Ticking…
Complicating matters, the IRS imposes rigid timelines for identifying and purchasing these replacement properties—45 days and 180 days respectively. These timelines are long enough to withstand long closing periods, but they are short enough to solicit immediate action. If you are in the process of selling a property and would like to perform a 1031 exchange but you have no replacement candidates, get help immediately!
Please keep in mind that I am not an accountant and, as such, this information is provided for informational purposes. See your tax preparer and CPA for specific information regarding your tax situation. Next week, we will explore an example 1031 exchange (in detail) such that you get a (hopefully) crystal clear understanding of how this powerful tool works. I will also counter the standard (yet misguided) objections to such an exchange.
Until next time… Happy Investing!