A 1031 exchange involves a swap of like-kind real estate for like-kind real estate. Tax-deferred 1031 Exchanges are important for investors of commercial and income properties. Federal tax law allows taxpayers to defer capital gains tax on the exchange of property used in trade or business or held for investment. A 1031 exchange postpones taxes, it does not eliminate them. However when a property is transferred to an heir with the basis step-up that occurs, capital gains tax are forgiven at that time.
It is treated under the tax code as a continuation of the ownership of the property.
Can be used to:
- Increase equity by deferring capital gains tax
- Acquire property with more appreciation potential
- Consolidate assets by combining several properties into one larger asset or
- diversify holdings by exchanging one large asset for several smaller ones
- Acquire a future retirement residence
- Divide real estate holdings prior to distribution to heirs
- Relocate or increase investment holdings in another location
- Obtain space for business expansion
- Dispose of underperforming property Increase net cash flows by acquiring a property with better financing Obtain non-taxable cash by acquiring property that can be mortgaged
Documenting the Intent to Exchange
When the intent is to transfer and acquire property through a tax-deferred 1031 exchange, the purchase and sale agreement (or an addendum) should contain language reflecting the intent and requesting the other party’s cooperation. If the exchanger decides prior to closing not to proceed with the exchange, the transaction is simply closed as a taxable transaction. The wording could be as follows: “It is the intent of the seller to perform a Section 1031 exchange seller is asking for the cooperate of the buyer by signing an Assignment Agreement at no cost or liability to the buyer.”
Cash or non-like kind property, known as boot, received in an exchange is taxable. Mortgage relief is also considered taxable boot. Although the exchanger is taxed on the boot received, that amount will be less than the amount of capital gains tax owed on an outright sale of the property. In any case, the amount of tax owed on boot can never exceed what would be owed on a sale.
What Is Like-Kind?
Like-kind refers to the use of the property. A property used in trade or business or held for investment must be exchanged for property to be used in trade or business or held for investment.
- A condominium for an office building
- A rental house for an apartment building
- Bare land for a multiunit rental
- Ranch land for a duplex