The 1031 Exchange (IRC §1031)

Investors must remember that when they sell a property, taxes are paid on the capital gains - not equity or profit.  Therefore, understanding the allowable tax benefits under the Internal Revenue Code §1031 is vital to save money, create leverage towards future purchases and allow you to build wealth.

The 1031 Tax Exchange essentially allows you to "sell" your investment property and "purchase" another investment property - all without paying taxes under the condition that you follow certain guidelines throughout the process from start to end. 

Here's a Generic Scenario of How it works... in a nutshell:

• Mr. Green owns a 4-unit rental building in Atlanta but wants to move his investment interests to Coastal Georgia.
• He finds a Qualified Intermediary (QI)
• He discloses his 1031 intentions on his listing agreement and starts looking for a buyer in Atlanta who wants his building.
• He begins looking for Investment property in Glynn County.
• When he finds a Buyer, he notes in the purchase contract that this sale is part of a 1031 Exchange.
• At close of his rental property in Atlanta, he transfers the deed to the new Owner.  The closing attorney transfer the proceeds from the sale to the QI.
• Mr. Green now officially has 45 days to identify the property to be exchanged and inform the QI in writing.  The IRS provides this time understanding that you may not always have properties ready and available to exchange at the same time.
• Mr. Green finds a shopping center for sale in Brunswick.
• He notifies the QI and makes an offer which is accepted.  In his purchase agreement, he discloses that this purchase is part of a 1031 Exchange.
• In this case, the property was of greater value, so he obtains a mortgage to cover the difference between his proceeds from the rental property and the shopping center. 
• At close, the Seller transfers the deed to Mr. Green, the closing attorney passes the lender's check to the Seller and the QI transfers the proceeds from the original sale to the Seller.
• Mr. Green now owns a shopping center and paid no taxes for the sale of his rental building.

Consider the Tax Savings:

• In the example above, had Mr. Green simply sold his rental building for a gain of $300,000, he could have potential tax implications up to $105,000 leaving him only $195,000 to re-invest.
  • If he wanted to use that $195,000 as 20% down-payment toward his next venture, he would be limited to $975,000.
• Using the 1031 Exchange, he takes the entire $300,000 gain and re-invests it into his shopping center.
  • Using that $300,000 as down-payment for his next venture at 20%, he would be able to afford a shopping center worth $1,500,000.

Basic Rules to Remember...

• Property must be like-kind in order to qualify for exchange.  The IRS defines like-kind as any property used for business or investment.  So you are not limited to house for house or shopping center for shopping center.  You can exchange for any category of investment property that is used for business or investment. 
• The Exchange must be completed with the exact amount of money or more being used in the purchase portion of the exchange.  If the exchanger purchases a property for less than the amount of the initial sale and receives any money back, it is considered a "boot" and it will be taxable.
• The Exchanger, in completing the exchange, must move laterally or up in Value, Equity and Mortgage. Any drop in any of the three will result in a "Boot" which will be taxable. 
• Any property under contract can be revised to reflect participation in a 1031 Exchange.  For instance, you currently have a property under contract to close in say..ten days and while reading this page, a light bulb flashes over your head... simply call your real estate agent and ask her to add an amendment to the contract stating your intent.  There is a pre-written special stipulation in the Georgia Association of REALTORS forms packet which we all use in the state of Georgia.
• You have 45 days from the close of your property to identify in writing to the QI the property or properties you wish to purchase as the final part of the exchange.  You can technically notify your QI prior to closing if you already know what you're going to purchase. 
• You then have 180 days from the close of your property to complete the exchange by purchasing one of the properties identified to the QI.  After 180 days, the exchange has failed and the initial sale of your property becomes a TAXABLE event and Mr. Taxman will come calling...
• If you own residential rental property like a single-family home or a condominium, in order to qualify as an investment, the home must be made available to the public as a rental property for an 'acceptable' length of time on the market.  You can't own a second home and decide one day that it's a rental property and then turn around and try to exchange it as investment property in order to qualify for the exchange.  A property must be available to the rental market for a reasonable length of time, with or without tenants.  While the IRS sets no specific time limits, rules of good judgment apply when considering what will raise the auditor's eyebrows...some use the time frame one year plus one day.

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