What is a Section 1031 exchange?
In the mortgage industry you will hear quite often about the section 1031
exchange, it is recognized as the tax-deferred exchange or real estate
exchange, was created in 1990 by the I.R.S.
A Section 1031 exchange is the process of selling one real estate
investment for the purchase of other real estate investments. When
used with a mortgage, homeowner's will usually sell one of their real estate
investment holdings to purchase some other, comparable property, they can
then offset or straight out avoid capital gains tax. The real estate
property or properties which are sold is called a "released property" and
the property acquired is called "replacement property”.
Before the introduction of the 1031 exchange, a homeowner had to sell one
place ahead of the close of escrow on the new property, a practice which
proved to be very difficult.
The I.R.S. ultimately advised a solution with the introduction of the
1031 exchange, which in effect allows a homeowner to sell the released
property, payoff the existing mortgage and apply the proceeds to buy the
replacement property later. In order for the exchange to work
properly, it has to be overseen by a qualified intermediator and certain
rules must be adhered to.
Real estate is divided into four categories, including property
obtained for business purposes, investment property, personal property ,
and property held principally for sale. The first two allow for a 1031
exchange, while the last 2 do not.
All proceeds from the released holding sale must be invested in the
replacement property. The exchange of properties needs to be of
like-kind, meaning that classification of the properties is the same, and
not established on their quality or condition.
There are also certain time requirements that must be rigorously
observed. The designation period starts the date the relinquished
property is transferred and expires after 45 days. The exchange period
begins on the date you transfer the relinquished property and ends after 180
days or earlier if tax returns for the taxable year are submitted before
those 180 days.
There needs to be an actual exchange, supervised by a qualified
intermediary, and not just a reassign of property for money only.
It’s always wise to look for the services of a professional early on to
avoid any expensive errors when executing a section 1031 exchange.
Click here for 1031 exchange requirements