1031 Exchanges and Avoidance of Capital Gains Upon Sale of Commercial & Investment Real Estate

In 1997, Congress passed new, generous rules that effectively eliminate capital gains tax on the sale of the primary residence. But what happens if you are selling any other classification of real estate investment property, business property, vacation home, etc.? You will be taxed on your profit unless you use the IRS Section 1031 Exchange Rule.

What is a 1031 Exchange?

A 1031 Exchange is essentially combination of two transactions. First, you sell your property to a third party for value and then you purchase another property (or vice versa, - purchase and then a sale). If you structure the transaction in accordance with IRS rules and regulations, you will not incur capital gains tax on the sale. The IRS will consider the two transactions as an "exchange" of property – from the one you sold to the one purchased. There will not be any immediate tax consequence.

When should you use the technique?

Anytime you are selling real estate that is not your primary residence and are faced with significant capital gains.

How do you do an Exchange?

Your sale and subsequent purchase must take place within 180 days. Special paperwork links these two events together and allows them to qualify as an Exchange. Sale proceeds must be deposited in a special account during the period between the sale and purchase. Exchange Rules require that you designate a Qualified Intermediary to perform these services. Follow the explanation below to see how it works:

1. The Exchanger enters into a Contract to sell to anyone who wants to buy.

2. The Exchanger enters into an Exchange Agreement with a Qualified Intermediary.

3. The Contract for Sale between the Exchanger and the Buyer is assigned to the Qualified Intermediary.

4. The Closing takes place, the Exchanger deeds the property directly to the Buyer and the sale proceeds are deposited with the Qualified Intermediary.

5. Within 45 days after Closing, Exchanger identifies possible replacement property to the Qualified Intermediary.

6. The Exchanger enters into a Contract to purchase whatever property is desired from the Seller of that property.

7. The Contract for Sale between the Exchanger and the Seller is assigned to the Qualified Intermediary.

8. The Closing takes place within 180 days of the first closing, Seller deeds directly to the Exchanger, and the monies held by the Qualified Intermediary pay for the purchase.

9. The Exchange has been completed and no tax is owed. What really occurred is a Sale and subsequent purchase that were made interdependent through use of the Exchange technique and use of a Qualified Intermediary.

If you need legal advice on 1031 exchanges, contact Michael J. Anthony, Esq.