A 1031 exchange refers to Section 1.1031 of the Internal Revenue Code
which was passed in 1990. Normally, when you sell all real and personal
property, the tax code requires the payment of the Capital Gains Tax.
That is to say, when you sell your office for $100,000 more than you
bought it for, you must pay the gains upon those earnings. However,
after the passing of a 1031 Exchange that is no longer necessarily the
case.
What types of Property Qualify?
A 1031 Exchange allows sellers of some real and personal property the
opportunity to avoid paying capital gains taxes (which are 15% plus
state taxes) by “exchanging” their sold property for newly purchased
property. However, certain restrictions apply. The most important
restriction is that only business property and investment property
applies. So, an exchange under a purely residential home does not
qualify, whereas exchanging a property that your business has used for
its office, or even one used simply for investment diversification
does.
But simply selling your office isn’t enough to qualify you for a 1031
exchange. Rather, the code also requires that that you simultaneously
buy a property of “like-kind.” This does not mean that if you are
selling a 2000 sq. ft. office you must buy a 2000 sq. ft office.
Rather, the term is interpreted very loosely to mean virtually any real
estate held for productive use in a business or for investment, whether
improved or unimproved can be exchanged for any other property to be
used for productive business or investment purposes. So, if you sell
and unimproved lot of land and purchase an improved one or visa versa,
this still qualifies, just as selling industrial property and buying
rental resort property does. The point here is that while “like-kind”
is an important restriction, it has been interpreted so broadly as to
give individuals a lot of free reign.
The Exchange
When most owners envision a 1031 exchange they envision a provision
whereby they must buy and sell the two properties on the same week or
even the same day. But that is not the case. A tax-deferred 1031
exchange allows up to 180 calendar days between the sale of the first
property and the purchase of the second. But no matter the time between
sale and purchase, a 1031 exchange is required by the Internal Revenue
code to have a “qualified intermediary” to manage the exchange.
A Qualified Intermediary
The requirement of a qualified intermediary is intended primarily to
prevent individuals engaged in the exchange from using the time in
between the sale and purchase of property to their financial gain.
Although the seller has up to 45 days to set up the intermediary, the
exchange is designed so that the seller should not profit from the use
of the money before the purchase of the new property is made. An
intermediary serves the judicial purpose of ensuring this. But it is
important to remember that the qualified intermediary charges fee for
this. While these services can vary in cost depending on the additional
advisory services provided by the Intermediary, individuals interested
in a 1031 exchange should expect to pay somewhere in the vicinity of
$500 to $700 for the first exchange and $200 to $400 for each
additional property.
