1031 Exchange or Like Kind Exchange is a term defined in the IRS Code, section 1031. In simple words, 1031 enables home sellers to defer paying capital gains taxes as long as they exchange a like-kind property. Though the definition is simple, there are some rules that you must be aware of.
The rules
Rule 1 - It must be a like-kind property
It is not possible to exchange just any property for the one you are selling. It must be the perfect exchange in terms of grade and quality. Here are possible and impossible exchanges for you:
- an apartment building for a duplex - possible
- a house for a farming equipment - impossible
- a single family rental property in exchange for office building - possible
Rule 2 - Replace one for many
Yes, it is possible to exchange one property for multiple properties. The only thing is that you, and no one else must own the new properties. It would be a good idea if you could get a good intermediary to assist in this.
Rule 3 - 1031 Exchange applies for only commercial properties
Unfortunately, 1031 Exchange is applicable only for commercial and business properties. For example, if you move from California to Miami, you cannot move your personal property from there to here in the form of an 1031 Exchange purchase. If it is a single family rental property, you can exchange for a commercial rental property.
Rule 4 - Trading up
The net market value of the property sold and its equity must be equal or greater than the new property, if you want to defer 100% tax. If not, you will have to pay the tax difference. For example, if you are selling a property that’s worth $2,000,000 with a mortgage of $500,000, then the new property must be at least $2,000,000 with a $500,000 mortgage.
Rule 5- The closing must be within 6 months
You have 6 calendar months to buy a new property in exchange for the old property. You must also designate 45 calendar days to designate a replacement property. The 45 days and 6-month period run concurrently, so start counting the days once you sell the old property.
Conclusion
1031 stands by the side of the investor by shifting the focus of his investment without worrying about tax liabilities. It is also helpful for investors wishing to move his investment from one property to another in terms of location.