If you are in the process of selling a commercial or investment property, there is a good chance that someone involved in the transaction will mention the possibility of using a “1031 exchange.”   People sometimes call it a “like-kind exchange” or a “deferred exchange” or a “swap.”   These are just different names for the same thing.  “1031” is just the number of the section of the Internal Revenue Code that provides the rules that you have to follow if you want to qualify for the benefit of this special provision.

So what is a 1031 exchange and why would you want to do one?

Normally, when you sell an investment property, you are required to pay income tax on the gain (the difference between the amount you receive and your cost basis in the property).  Section 1031 contains a very useful exception to this general rule which effectively allows you to reinvest the proceeds from the sale of your property into another replacement property and defer paying all or much of the tax due until you sell the replacement property.

And when you later sell the replacement property, you can use section 1031 again to defer any gain on both properties.  There is no limit on the number of times that you can reinvest the proceeds from later sales. And if you die owning the property, there is a specific income tax provision which provides that no one will ever have to pay income tax on the accumulated gain.

So what are the rules that you have to follow to qualify for this useful provision?

First of all, you MUST have your ducks in a row before the closing on the sale of your property.  As a practical matter, you need to find a “qualified intermediary” who is knowledgeable enough to guide you through the process, and you must have a signed agreement with the intermediary before you close on the sale of your property.  You cannot document the transaction after the fact.  A commercial realtor or your accountant may be able to help you locate an intermediary.  (Reilly Wolfson has arrangements with two qualified intermediaries.)

Second, the property must be real property.  Not personal property like equipment, stock certificates or an interest in a partnership.

Third, the property must be investment or business property.  Your personal residence does not qualify.  And a beach house or vacation home will only qualify if you meet specific rules to establish that it is primarily an investment property that you lease to others.

Fourth, the property that you sell and the property that you acquire must be of “like-kind.”  This is a broadly defined term, but it basically allows you to swap just about any type of investment or business property for any other type of investment or business property.  For example, you can exchange farmland for an apartment building or an office building for a warehouse.  The primary restriction is that it cannot be a personal residence.

Fifth, you do not need to know which property or properties you will be acquiring when you close on the sale of your property.  But, you must have a qualified intermediary who will hold the sales proceeds and apply the proceeds toward the purchase of the replacement property.  And you must take certain actions within prescribed time limits.  Within 45 days of closing on the transferred property, the client must designate all of the eligible properties to be acquired.   And within six months of the closing date, you must complete the purchase of the replacement property.

Finally, as in many tax related matters, there are a number of traps that must be avoided and arcane illogical rules that must be obeyed.

The tremendous advantage of being allowed to reinvest the tax dollars that you would have otherwise paid to the U.S. Treasury upon the sale of your property makes Section 1031 a very useful and valuable tool.

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