Section 1031 of the Internal Revenue Code states “No gain or loss shall be recognized if property held for productive use in a trade or business or investment purposes is exchanged solely for property of a like-kind.”

Okay, so what does this mean?

If you have real property that will net you a gain upon sale, then you qualify for a 1031 exchange. Single or multiple properties may be exchanged in the transaction. A 1031 exchange allows you to sell investment property and defer capital gains and depreciation recapture taxes, assuming reinvestment of 100% of equity into “like-kind” property of equal or greater value.

Requirements for a 1031 Exchange

1. Identification Period

• You must identify your investment property (up to three at a time) within 45 days of the close of escrow on the relinquished property.
• The real property you sell must be held for productive use in a trade or business or for investment purposes.

2. Exchange Period

• You must identify and successfully complete the acquisition of the replacement property within 180 days of close, or the due date for the taxpayer tax return for the taxable year in which the transfer of the relinquished property occurs.
• The real property you purchase must also be held for productive use in a trade or business or for investment purposes and must be “like-kind.”
• It must also be subject to an equal level or greater level of debt than the relinquished property or the buyer will have to pay taxes on the amount of decrease, or put in additional cash funds to offset the lower level of debt.
• You may identify any amount of properties as replacements as long as the aggregate value of those properties do not exceed 200% of the value of your relinquished property.
• You may identify any amount of properties as replacements as long as you end up purchasing at least 95% of the aggregate value of all properties identified.

3. Qualified Intermediary

• A “qualified intermediary” must hold the proceeds from the relinquished properties during the 180-day period.
• All the cash proceeds from the original sale must be invested in the replacement property.
• The taxpayer cannot receive any proceeds from the sale, either actually or constructively, or else all the proceeds will become taxable.

Kinds of Property that qualify

• Real Property

The provision for like-kind Real property includes land, rental, and business property.

The IRS has four classifications for real estate:

1.      Property held for personal use (Personal Property)
2.      Property held primarily for sale (Dealer Property)
3.      Property held for productive use in a trade or business (Business          Property)
4.      Property held for investment (Investment Property)

Numbers 3 and 4 are the only kinds of real estate that qualify for 1031 exchanges. Like-kind refers to your use of the property. 1031 property may be mixed as to type and still be like-kind. For example, you may exchange a duplex for land, or a retail store for a commercial property. Property outside of the U.S. and its territories does not qualify for exchange with property held in the U.S.

• Partnership Interests

You cannot trade your interest in a partnership for an interest in another partnership. Although, the partnership of an entity can exchange real estate it owns for other like-kind real estate.

• Sale/Lease Back

Interest in a lease with a term of 30 years or longer in real property qualifies for like-kind to other real property. In addition, property that is subject to a lease can qualify for a tax-free exchange. However, the receipt of prepaid lease payments in exchange for a 30-year or longer lease is taxed as ordinary income and does not qualify as a tax-free exchange.

• Business Assets

The personal property assets of one business qualify as an exchange for like-kind assets of another business. The real property is treated the same as any other exchange, but the like-kind requirements are much more stringent than for real property. For example, a car cannot be exchanged for a truck.

• Vacation Homes and Properties

This type of property only qualifies if rented and must past a test each year.

Every exchange provides the opportunity for building wealth, but inexperienced investors would be wise to hire a qualified real estate professional to assure that the transaction is handled properly.