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A 1031 exchange refers to Section 1.1031 of
the Internal Revenue Code which was passed in 1990.
Normally, when you sell all real and personal property, the
tax code requires the payment of the Capital Gains Tax. That
is to say, when you sell your office for $100,000 more than
you bought it for, you must pay the gains upon those
earnings. However, after the passing of a 1031 Exchange that
is no longer necessarily the case. What types of Property
Qualify?
A 1031 Exchange allows sellers of some real and personal
property the opportunity to avoid paying capital gains taxes
(which are 15% plus state taxes) by “exchanging” their sold
property for newly purchased property. However, certain
restrictions apply. The most important restriction is that
only business property and investment property applies. So,
an exchange under a purely residential home does not
qualify, whereas exchanging a property that your business
has used for its office, or even one used simply for
investment diversification does.
But simply selling your office isn’t enough to qualify
you for a 1031 exchange. Rather, the code also requires that
that you simultaneously buy a property of “like-kind.” This
does not mean that if you are selling a 2000 sq. ft. office
you must buy a 2000 sq. ft office. Rather, the term is
interpreted very loosely to mean virtually any real estate
held for productive use in a business or for investment,
whether improved or unimproved can be exchanged for any
other property to be used for productive business or
investment purposes. So, if you sell and unimproved lot of
land and purchase an improved one or visa versa, this still
qualifies, just as selling industrial property and buying
rental resort property does. The point here is that while
“like-kind” is an important restriction, it has been
interpreted so broadly as to give individuals a lot of free
reign.
The Exchange
When most owners envision a 1031 exchange they envision a
provision whereby they must buy and sell the two properties
on the same week or even the same day. But that is not the
case. A tax-deferred 1031 exchange allows up to 180 calendar
days between the sale of the first property and the purchase
of the second. But no matter the time between sale and
purchase, a 1031 exchange is required by the Internal
Revenue code to have a “qualified intermediary” to manage
the exchange.
A Qualified Intermediary
The requirement of a qualified intermediary is intended
primarily to prevent individuals engaged in the exchange
from using the time in between the sale and purchase of
property to their financial gain. Although the seller has up
to 45 days to set up the intermediary, the exchange is
designed so that the seller should not profit from the use
of the money before the purchase of the new property is
made. An intermediary serves the judicial purpose of
ensuring this. But it is important to remember that the
qualified intermediary charges fee for this. While these
services can vary in cost depending on the additional
advisory services provided by the Intermediary, individuals
interested in a 1031 exchange should expect to pay somewhere
in the vicinity of $500 to $700 for the first exchange and
$200 to $400 for each additional property.
Dan Johnson enjoys writing about
1031 exchange.
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