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A 1031 exchange is an IRS approved transaction that allows owners of property to avoid paying capital gains taxes by exchanging one property for another. As a real estate investor, I use the rule to save money on taxes instead of selling a property for cash.
For example, I owned a large, empty lot in Los Angeles where we had once planned to build a duplex project. The lot appreciated in value, but did not bring in any income. When I went to sell it, I found the value had almost doubled, going from $300,000 to $550,000. But if I wanted to sell it, I would have to pay a 15% capital gains tax on the $250,000 increase in value.
Instead of selling the lot, I did a 1031 exchange with another developer and got a small office building, also worth $550,000. The office building generates monthly income through rent, so now I own something worth the same value as the empty lot, yet I'm earning a monthly income and I paid no capital gains tax on the transaction.
Based on my experience, here are a few key things to know about 1031 exchanges:
Like-kind properties
The IRS allows exchanges only between "like-kind" property. That basically means real estate must be exchanged for real estate. If you have a fleet or trucks or industrial equipment, they must be exchanged for something similar. The value can be different, even the condition can be different, but it has to be the same general type of asset.
Time limits
The transfer does not have to happen immediately (a simultaneous exchange). The proceeds from a sale can be put into escrow and there is a specific time period allowed to make the exchange ( a delayed exchange). To qualify, the seller must identify the property for exchange before closing, it can't be decided after the sale. The replacement property must be identified withing 45 days of closing, and the replacement property must be acquired within 180 days of closing.
Using a qualified intermediary
The IRS rules on 1031 exchanges are very strict and the exchange must be done through what the IRS calls a "qualified intermediary" or QI. These are normally realtors, attorneys or real estate brokers who specialize in 1031 exchange transactions. They must be unrelated to the exchanger, in fact they must not have had a financial relationship with the exchanger within the two years prior to the 1031 exchange. Investors cannot simply put the money into an escrow account and make the exchange purchase themselves, it must be done through a QI.
Use an expert
This is complicated real estate transaction and the tax law can be equally complicated. The cost of errors or mistakes may be tens of thousands of dollars. Work with a licensed real estate broker and attorney who are experienced in these transactions. I always ask for references and check with government agencies to ensure proper licensing.
There are a lot of rules about 1031 exchanges, the Federation of Exchange Accomodators, the professional trade organization for QIs, has an excellent informational section on its website which I find extremely helpful, even as someone who has done a number of exchanges already.
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