Section 1031 of the Internal Revenue Code provides a valuable tax deferral mechanism for real estate investors. The provision, commonly referred to as a "like-kind exchange," allows for the exchange of one investment property for another without immediate recognition of capital gains tax liability.
To be eligible for a Section 1031 exchange, the real estate being exchanged must be held for investment or for use in a trade or business and considered "like-kind,” meaning they are used for a similar purpose or are similar in nature or character.
Section 1031 requires adherence to strict time limits. The seller must identify the replacement within 45 days of the sale of the first property and must purchase the replacement property within 180 days. The replacement property must be of equal or greater value than the one that was sold. Otherwise, the seller will recognize capital gains on the excess sale proceeds.
The seller is prohibited from exercising control over the proceeds of the sale. Therefore, a crucial aspect is the involvement of a “qualified intermediary.” A qualified intermediary is an independent third party who holds the proceeds from the sale of the relinquished property until the new one is purchased.
A Section 1031 exchange is not a tax loophole or a means of avoiding taxes altogether. The deferral of capital gains tax liability is only temporary, and the deferred tax will be due when the seller decides to sell the replacement property.
If you have questions, contact your tax professional or call our office at 248.477.6300.