According to Investopedia, a 1031 Exchange is a swap of one investment property for another that allows capital gains taxes to be deferred. It gets its name from the IRS code Section 1031 which describes the exception to having to pay capital gains tax at the time of the sale of the property. The key to receiving tax deferment status is that the disposition, or sale, of one property occurs within an integrated transaction of acquiring, or purchase, of another. This must be done by using a 3rd party exchange facilitator (Accommodator) who ensures the rules are followed according to IRS guidelines.
In general, most real estate will be like-kind to other real estate and permitted to be exchanged. The quality or grade of the property does not matter. Some exceptions to this are any property primarily used for personal use or property outside the U.S. vs. inside the U.S. There are other exceptions outside of real estate but for this discussion we will focus on Real Estate.
The time limits are critical for an eligible exchange. The three primary trigger events are selling the property, identifying potential replacement properties, and completing the purchase. Our friends over at BiggerPockets have put together a great infographic showing the applicable timeline.
It is worth noting that the only exception to these timelines is in the case of a presidentially declared disaster. One often overlooked aspect of the Exchange is that these exchanges must be done prior to the due date of the income tax return for the year in which the property was sold. Income Tax filing extensions are applicable here, so the return can be put on extension if needed!
Biden’s Proposed Tax Plan
Ironically the 1031 Exchange program went into effect in 1921, exactly 100 years ago. The President’s draft of the new tax plan calls for a significant cut to the 1031 Exchange – limiting the tax deferral to $500,000 in Capital Gains. Capital Gains above this amount are proposed to be taxed at 39.6% instead of the 20% long term rate currently. The arguement could be made (and is being made by some CPAs), that it is better to realize the capital gains now under the lower tax rate and receive the step up in basis to reinvest with after tax dollars. Others are encouraging the 1031 Exchange now if you’re in the market for to exchange a property. It is impossible to ascertain what the final tax package will look like and what will be grandfathered in and what won’t. Either way, it is a good idea to revisit your investment plan as it pertains to future tax consequences.
If you’re interested in learning how CSQ is Exchanging apartment buildings into larger buildings, please schedule a call with us!