1031 Exchange – Benefits and Rules

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Author: Ray Smith

Article source: http://www.articlealley.com/. Used with author's permission.

Section 1031 of the IRS offers a golden opportunity for real estate investors to defer their capital gain taxes by reinvesting their sales proceeds in purchase of another like kind property. One important condition that governs this law is that the transaction needs to take place within 45 days of selling the property.

The benefit potential of a 1031 exchange can be better comprehended if we look into a case study…

An investor gains $400,000, by selling his land and incurs a total tax amount of $120,000. He is left with $280,000 after the transaction is complete.

If the seller wants to reinvest the proceeds for a new property, considering a 25% down payment with 75% loan to value ratio, he will be able to buy a property worth $1,120,000.

Had this been a 1031 exchange the seller could reinvest the entire sales proceed of $400,000 and with same loan to value ratio he could have availed a property worth 1,600,000.

With the increasing awareness about 1031 exchange and its benefits more and more people are investing in real estate, however, to gain the maximum out of it, it is important that we have a clear understanding of all the terms and conditions mentioned in this section of the IRS.

The rules for a successful 1031 exchange has been clearly laid down in section 1031 of the IRS and can be explained as given below.

• The foundation of 1031 exchange rule is that only properties held for productive purpose in a business or trade or for investment purposes qualify for a 1031 exchange.
• The properties involved in the transaction should also be of like kind. Under Section 1031, one kind or class of property should be exchanged for another property of the same kind or class. A taxpayer's personal residence cannot be exchanged for income property, and income or investment property cannot be exchanged for a personal residence, which the taxpayer will reside in.
• Section 1031 of the IRS also marks the guidelines about the sales proceeds. It stated that the entire amount from the sales proceeds should be reinvested towards acquisition of the new property. The sales proceeds should also go through the hands of a qualified intermediary and not through the seller or the seller's agent. Any cash proceed from the sale, if retained, becomes taxable.
• For a successful 1031 exchange there are also some time limitations laid down in Section 1031, which needs to be followed.

  Identification Period: This is a 45 days period from the day of selling the relinquished property during which the seller needs to identify a replacement property that he proposes to buy. This is a strict timeline and is not extended even if the 45th day falls on a holiday or on weekends.

  Exchange period: This is the period within which the seller of the relinquished property needs to receive the replacement property. This period ends at 180 days after the date on which the person transfers the property relinquished or the due date for the person's tax return for the taxable year in which the transfer of the relinquished property occurred, whichever is earlier. This is a strict timeline and cannot be extended even if the 180th day falls on a holiday or on weekends.

These are some of the basic rules that need to be followed to complete a successful 1031 exchange. While qualified intermediaries are an indispensable party to a 1031 exchange transaction and can often provide good advice, it is advisable that you do proper study about this section of the IRS and consult a knowledgeable company for professional advice on 1031 exchange.