What is a 1031 Tax Exchange in Real Estate?

What is a 1031 Tax Exchange in Real Estate

Whenever property is sold, the income gained on that property is taxable according to the IRS. A 1031 Tax Exchange is the portion of the U.S. Internal Revenue Code that allows for the taxes on income from a real estate transaction to be deferred as long as it is invested in another real estate purchase. For a transaction to qualify for a 1031 Exchange, there are specific rules and requirements, which is why it helps to work with a professional. Here’s what you need to know about this tax law and how to take advantage of it for yourself.

Who Can Benefit from a 1031 Tax Exchange?

Anyone who is selling or buying real estate can benefit from a 1031 Tax Exchange. This includes individuals, investors, homebuyers, landlords, businesses, and others. Real estate investors have the most to gain from this tax law, as it allows them to sell and purchase property without paying taxes on the property at the time of sale. As long as the property sold and the new property purchased are considered to be “like-kind”, essentially meaning that both items are real estate property.

What Does “Like-kind” Mean?

The 1031 Tax Exchange law states that in order for taxes to be deferred, the property being purchased must be in “like-kind” to the property being sold. The concept of “like-kind” is relatively flexible, but it must be real estate, not other goods. One example of an acceptable exchange is vacant land for a commercial property. Industrial property can even be exchanged for residential property. However, the exchange property for a vehicle or some other large purchase that would not be considered real estate, does not apply and would still be subject to taxes. The quality of the property does not play a part in the concept of like-kind. One property may be significantly higher quality than the other, but they can still be eligible for the 1031 Tax Exchange.

Do Both Properties Have to be Equal Value?

In order to completely defer taxes in a 1031 Tax Exchange, the property being sold must be of equal or lesser value than the property being purchased. If the property being purchased is of lesser value than the property being sold, the difference (referred to as “the boot”) is taxable.

How Important is Timing in a 1031 Tax Exchange?

To take advantage of the 1031 Tax Exchange, the property sale and purchase does not have to happen simultaneously. There is a period of 180 days that can pass between the sale of one property and the purchase of another where the tax can still be deferred.

Does a 1031 Tax Exchange Apply for Residential and Commercial Property?

Both commercial and residential closings can qualify for a 1031 Exchange. One type doesn’t necessarily have to be exchanged for the same type of property, as long as both are considered to be real estate transactions. How Does Depreciation Affect Things? Depreciation refers to the loss in value that occurs over time for a particular property. Due to wear and tear, a property may depreciate somewhat each year. The depreciation is typically written off on the taxes on a yearly basis, but when the property is sold it may be recaptured. This means that the depreciated value that was previously written off may be applied to the taxable income of the sale.

What is the Role of the Title Insurance Company in a 1031 Exchange?

Title insurance companies may play a few different roles in real estate transactions. A title insurance company primarily provides title insurance and conducts the title search to ensure there is a clear chain of title for the property being bought or sold. In the case of a 1031 Tax Exchange transaction, the title insurance company may play the role of the qualified intermediary as well as an escrow officer. This means that they will hold tax funds in escrow between the sale of one property and the purchase of another, such as during the 180 day allowed period.

Learn More About 1031 Tax Exchanges from American Guardian Title

If you want to know how to take full advantage of the 1031 Tax Exchange law, American Guardian Title can help. We provide a wide range of real estate services including title insurance and tax assistance.