1031 Like-Kind Exchanges
The gain, or earnings from the sale of a property are usually taxed at the time of the sale. However, a 1031 Like-Kind Exchange provides an exception. It postpones the taxation on the earnings, if it is reinvested in a similar and qualified property, and it only applies to business and investment properties. A 1031 Exchange is important to a property investor because he has more cash on-hand to immediately reinvest into another property since the taxes on the gain from the sale of his initial property have been postponed to a later date, or deferred. Because quality and grade are not factors for Like-Kind Exchanges, the investor has the potential to upgrade his property portfolio without having to pay immediate or additional taxes.
Under a 1031 Like-Kind Exchange, when two or more properties are exchanged, the investment is still considered the same, just in a different form (e.g. a vacant lot exchanged for an office building). In the government’s eyes, since the investor is just switching the form of his investment, the investor has not gained any additional earnings to pay taxes. This is when the 1031 Exchange comes into play. By postponing the tax, the investor has more money on-hand to immediately reinvest into another property. Basically, a 1031 Exchange acts as an interest free loan from the government in the amount that would have been taxed otherwise. Although the gain may be immediately tax-free, it can be taxed at a later date.
When considering a 1031 Exchange, the properties (real or personal) being considered and exchanged must meet certain requirements.
Although a Qualified Intermediary (QI) is not required, one is commonly used to facilitate an Exchange. A QI is an independent party established by Treasury Regulations to facilitate the exchange of properties. The importance of the QI is to help ensure that the investor can still meet the exchange requirement because the exchange is over as soon as the investor comes into control of the gains from the sale of his initial property. The role of the QI is to first acquire the investor's initial property and sell it to a buyer to exchange with. The QI then holds the gains from the sale so that the investor does not come into control of the earnings before exchanging properties (which would automatically disqualify him from the Exchange). Finally, the QI purchases the replacement property and proceeds to transfer the property to the original investor.
1031 Exchanges apply to both real (realty, specifically business and investment) and personal property. The five types of exchanges are described below.
Even though a 1031 Exchange does not have to be a simultaneous property swap, the investor must meet two deadlines within 45 and 180 days of the sale of his property. If the investor does not meet both of these deadlines, the entire gain from the sale is taxable.