The number “1031” refers to Section 1031 of the U.S. Internal Revenue Code. A 1031 exchange is a strategy, according to Realty Mogul, used by real estate investors to defer capital gains income taxes (or income tax losses). Normally sellers of homes, buildings, and land must pay capital gains taxes at the time they sell their real estate. Section 1031 is a way to defer that capital tax until a later time. Investors like it because it helps them accumulate wealth.
Before 2018, there were non-real-estate investments that could take advantage of IRS rule 1031. The Tax Cuts and Jobs Act of 2017 changed Rule 1031 so that it now only applies to real property.
A quick example
You own real estate that you bought for $200,000. You make improvements to the property and wait for the right time to sell. When the time is ripe, after waiting for more than one year, you sell the real estate for $450,000 more than doubling your investment. Normally, you’d have to pay capital gains taxes on the $250,000 profit you made. If your income is approximately between $40,000 and $434,000, you would have to pay 15% capital gains on the $250,000 increase – or about $37,500.
If however, you invest the profits in new real estate and meet the 1031 exchange requirements, you don’t pay any capital gains tax at the time of the sale.
Eventually, the investor will have to pay capital gains taxes on the real property. But there are often significant tax, business, real estate, and other benefits to waiting.
The “like-kind” (in-kind) requirement
Previously, IRS rule 1031 applies to many different types of investments. The old rule required that real estate be traded for real estate, stocks for stocks, and so-on. Now, since the rule only applies to real property, real property must be exchanged for real property for 1031 eligibility. The in-kind requirement is fairly broad though. Duplexes can be exchanged for condos, single homes for townhouses.
There are some exceptions an experienced Florida real estate lawyer can explain. For example, both properties should be located in the United States. Section 1031 doesn’t apply to homeowners. So, Uncle Phil can’t sell his family home in New York and move to another home in Florida – and use rule 1031. 1031 is aimed at investments
1031 exchanges and improvements
The rule doesn’t benefit investors who sell improvements, according to Realty Mogul, unless the land is conveyed with it. An experienced real estate lawyer and /or a tax lawyer can help advise investors whether their contemplated transfer is indeed “in-kind”
Other 1031 restrictions
Other issues to review with experienced legal professionals include:
- Transfers if you don’t own the real estate. 1031 generally requires that the seller owns the full property. “Owning a share in a REIT, a fund, or an LLC that owns a share in another LLC does not qualify.”
- 1031 only applies to real property, and not to personal property
- In most cases, investors hope to exchange their property for more valuable property. If the investors' exchanges for less valuable property, other tax issues may apply
- There are additional complications if the investor uses a third party who “acts as an intermediary between you and a prospective future buyer.” Third-party intermediaries may be required if the sale is not simultaneous – if the transfer of the property and the transfer of the sales proceeds do not occur at the same time.
1031 exchange deadlines
You can’t wait forever to buy a new investment property. Generally, investors must identify new investment property they want to buy within 45 days of the sale of the old investment real estate. There are legal formalities that define “identify.” You need to put the identification in writing and comply with other requirements experienced tax and real estate lawyers can explain.
You must complete the exchange of the second property within 180 days of the sale of the first.
Comply with 1031 and you be able to defer a lot of taxes. Fail to comply and you will have to pay federal capital gains taxes on the real estate sale.
Other 1031 real estate considerations
Homeowners who buy a second home generally can not use 1031 to help defer taxes on the purchases of a second home. The home should be an investment, not a place where the seller may live if even for just a small amount of time.
Attorneys as closing agents
According to the First Exchange Mortgage Company, there are issues in 1031 exchanges involving using attorneys as closing agents. “When acting as a closing agent, the attorney receives the purchase price from the buyer and, once the closing occurs, disburses it to the seller. “
A key component of a 1031 exchange is that the transfer of the real estate is an actual exchange and not a sale followed by a later purchase.
A common question is who is the lawyer acting as an agent for and can the lawyer act as the closing agent. Possible solutions include having “the title insurance underwriter, an escrow company or an attorney who is not an agent of the taxpayer handle the receipt and disbursement of the funds.”