Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.
A Like-Kind Exchange can be personal property as well as real property. The IRS rules state that as long as the gain from an investment transaction is reinvested within a certain period of time into another investment that is similar, that the gain from the investment is tax-deferred. This does not mean that a sale can take place for cash with the reinvestment of the cash into a similar venture. Some examples of personal property that could be used in a Like-Kind Exchange include oil drilling rights, mineral rights, membership interest in an LLC, and others that are considered an investment. However this particular discussion will focus on real estate. real estate used primarily for investment purposes does not include vacation homes or those used as a residence.
If the sale of investment real estate is contemplated it is best to consult as soon as possible with an attorney who is knowledgeable about the details of 1031 exchanges. Some issues that might arise from a 1031 exchange of real property may include when and how to use the qualified intermediary, meeting the "held for" requirement, computation of gain and basis for the transaction, timing of the exchange, and meeting the 45 day identification requirement, among others.
Some investment real estate may be held within a separate business entity such as a partnership or an LLC. Some of these entity held real estate transactions transactions that may require multiple steps, such as a "swap and drop'", "drop and swap", or one tailored with "safe harbor parking" to accomplish a proper 1031 exchange. Due diligence is necessary to determine if a Like Kind Exchange can be used and if so how many steps may be needed to fulfill the requirements. Likewise due diligence is necessary when calculating the basis and gain or even a possible loss. Additional steps may be required when dealing with "troubled", otherwise known as underwater, property. If calculations are incorrect the purpose of the 1031 exchange may be defeated. Additionally, depending on the contract with the lender or local taxing authority there could be unintended consequences of a 1031 exchange such as triggering bad boy covenants or real estate transfer taxes.
A Like-Kind 1031 Exchange can be simple or can be complex. It is a useful tool for investment portfolios. The most important step in a Like-Kind Exchange is to work with knowledgeable individuals who perform thorough due diligence. Owners of investment property considering a transaction should always consider whether or not to use a Like-Kind 1031 Exchange.
