When property is sold, the seller pays national tax on any gain or deducts for reductions. Section 1031 of the tax code provides citizens an opportunity to defer any gain on the sale of qualified property. Most trades are completed through a business which specializes in 1031 exchanges (an intermediary). The IRS has published rules (safe haven rules) to get an intermediary aided swap. If these principles are followed, the IRS won’t challenge the trade. This safe harbor is a main reason for using an intermediary to assist in the market.
The 1031 exchange provision is only for investment and business property, and that means you can not swap your main residence for another residence. There are ways that you can use a 1031 for swapping holiday homes, yet this loophole is a lot narrower than it was. Many 1031 exchanges involve real estate, nevertheless, some exchanges of personal property (say a painting) can be eligible. Notice , that exchanges of corporate stock or partnership interests don’t qualify. On the flip side, interests as a tenant in common in real estate perform.
Most exchanges should only be of “like-kind”, a term that does not mean exactly what you think it means. You can swap an apartment building for raw land, or even a ranch for a retail center. The principles are amazingly liberal. You may even exchange one company for a different but there are traps for the unwary.
When an intermediary is utilized, an exchange may convey the sold property (relinquished property) right to a purchaser with the proceeds of the sale paid directly to the intermediary. When the exchanger purchases the replacement property, the intermediary pays the exchange funds to the vendor of the replacement property. Title to the house usually does not pass through the intermediary.
Under Section 1031 tax on a gain is postponed, maybe not entirely forgiven. Finally when the replacement property is sold, the tax on the deferred gain must be compensated unless additional provisions of this tax code are used to completely eliminate the taxable gain.
Timing for 1031 Exchanges
There are two critical time intervals for exchanges: the identification period and the trade period. Both start on the date the relinquished property is sold and operate simultaneously.
The identification period is 45 days. During this 45-day phase replacement property must be designated or identified in writing. If the replacement land is not identified within this 45 day period, the exchange fails and all profit realized from the sale of the replacement home will be taxable.
The exchange must be completed within 180 days of the closing date to the relinquished property. This 180 day period runs concurrently with the 45-day designation period. It is not inserted to the end of the designation period. It is not feasible to extend either the identification period or the trade period.
If the exchanger records a tax return for the year of the trade, the exchange period is terminated. When an exchange has not yet been done by the date a tax return is expected, a request for an extension of time to file the tax return must be submitted in order to get the entire 180 day interval to complete an exchange.
Steps to Follow in a 1031 Exchange
After the sale of their relinquished property, the sales proceeds need to be sent to the qualified intermediary pending the purchase of the replacement house.
Identify replacement property within 45 days of the sale of their relinquished property. Following the 45-day identification interval, only real property identified as potential replacement property qualifies as replacement property.
Contract to Buy replacement property.
Notify the intermediary of the contract to purchase replacement property and supply information about the closing of the purchase.
Within 180 days of the date of sale of relinquished property, purchase the replacement property, using exchange proceeds held by the intermediary.
The 180-day purchase period runs concurrently with the 45 day identification period.