Let’s talk about 1031 – not Halloween, but something that faced its own scare this fall – the tax deferment program used by many commercial real estate investors. The original version of the American Families Plan proposed a $500,000 cap on the popular capital gains deferment vehicle. However, the most recent version of the bill to come out of the House Ways & Means Committee leaves Section 1031 of the tax code intact. While the final bill could still make changes to the program, it is not likely that the previously proposed changes will be reintroduced in the future.
But what is a 1031 Exchange?
The 1031 like kind exchange refers to a provision in Section 1031 of the US Internal Revenue Code. It allows a seller of real estate to defer the capital gains tax on the sale of property by using the profits to purchase a similar investment within a mandated time frame. While there is no limit on the number of times an investor can roll over capital gains into a new investment using the 1031 exchange, there are specific steps that investors must go through to avail themselves of the tax deferment.
In a simple delayed exchange, capital gains from the sale of the original property must be placed with a Qualified Intermediary (QI) upon the closing of the sale. The seller then has 45 days to identify the replacement property and 180 days to complete the purchase. Once the replacement property has been identified and the purchase has been made, the qualified intermediary will transfer the funds to the seller at closing.
Investors can also complete what is called a Reverse 1031 Exchange. In this case, an investor with multiple investment properties may first purchase the replacement property, which is transferred to an exchange accommodation titleholder. The exchange accommodation titleholder can be the qualified intermediary and will hold title to the replacement property until the property being exchanged is sold. The investor has 45 days from the purchase of the replacement property to identify the exchange property to be sold and must close on the transaction within 180 days of the original transaction. These are just a couple of examples of what is possible in the 1031 exchange process. The rules for choosing replacement properties, depreciation, qualified intermediaries, and corporations can be quite hairy.
To avoid any frightful 1031 experiences and make your exchange less tricky and more treaty, it’s a good idea to find a team of professionals that are knowledgeable and experienced, including a qualified intermediary, a real estate broker that understands 1031 exchanges, an experienced attorney, a CPA and a certified closing agent. Because the only thing that should be scary about a 1031 is the coordinated Batman movie costumes the staff at your bank is wearing this season.
