Section 1031 of US tax code

The 1031 tax exchange is a method often used by property investors so that they may indefinitely defer capital gains tax liability on the sale of a property. This is achieved by transferring rights to a property one would like to sell to a qualified intermediary, who holds on to the funds gained from the sale of the relinquished property and uses them to acquire a replacement that complies with the rules set out in Section 1031 of US tax code.

While the present popularity of the 1031 tax exchange may lead one to believe that it only recently came on the scene, this is untrue. Actually, the history of the 1031 exchange extends as far back as 1921, although it was originally was significantly different from the exchange investors know and love. Section 1031 truly came into its own in the ’70s, which saw a host of significant modifications in the way that these exchanges were conducted. These modifications resulted in a more powerful conception of the 1031 process and also created greater interest among real estate investors.

The capital gains tax deferral a 1031 exchange provides to the taxpayer might, at first glance, seem to be a sort of gift from the United States government, however it is, in reality, more like an interest free loan. This is because there is an expectation that the taxpayer will repay the money gained from the tax deferral by paying capital gains taxes on the eventual sale of a replacement property. In addition, this interest free loan is one that may be kept by the investor for an indefinite period of time; an investor may conduct any number of exchanges before ultimately electing to make an outright sale, on which capital gains taxes must be paid.

Section 1031 of US tax code represents a mutually advantageous agreement between the investor and the U.S. government, providing a benefit for the U.S. economy as a whole in addition to the individual taxpayer. In viewing the transfer of value in an exchange as a continuation of an existing investment rather than as a separate transaction liable for taxation, investors gain the opportunity to transfer their money into the best possible investments. This, in turn, boosts the country’s economy by encouraging the growth of new jobs.

As with anything, Section 1031 has detractors. Some advocates of change in Section 1031 will pose the argument that the tax free profit provided to the investor in the exchange process creates an unreasonable advantage. Another common concern is that the strict time limits imposed on some aspects of the exchange process may engender a frenetic rate of buying, with a resultant increase in asking prices for replacement properties. These complaints, however, are only tenuously linked to reality, and the odds that Section 1031 will see any significant changes in the foreseeable future are quite slim. When looking at the big picture, most will concede that the 1031 exchange is immensely advantageous to all parties involved, allowing taxpayers increased profits on the sale of their property while also promoting the creation of jobs and consequently promoting the greater good of the U.S. as a whole. Little doubt exists that the 1031 tax exchange is destined to remain a part of the investment world for decades to come.

1031 To Your Dream Property

An essential fact in regard to 1031 exchanges is that you may not make use of the proceeds of the original sale to construct property you own. This is a frequent pitfall of unwary real estate investors. In order to qualify for a capital gains tax deferral, your replacement property has to be of LIKE KIND with the property it is replacing. Thusly, the property you acquire as a result of the 1031 exchange has to constitute real estate with a value greater than or equal to that of the property sold. An improvement that is incomplete is considered a contract for a service, which constitutes personal property but not real estate. Due to the fact that a property acquired in a 1031 exchange has to be of like kind and equivalent value with the property sold upon closing, it can be hard to find a property that complies with these legal requirements but also fulfills his or her specifications.

So, is there a way to what you really want out of a exchange? There are two main methods by which you can acquire a build-to-suit property that fits your wants and needs as well as fulfilling the accounting requirements necessary for a like-kind exchange.

The first option is to conduct what is known as a poor man’s build to suit in which you, as the purchaser, request that the seller make certain renovations on a piece of property to increase its value prior to closing on the sale. For example, if you were to sell a a piece of property with a value of $100,000, and you were considering a replacement property worth at $10,000, the seller of the property could construct ninety thousand dollars’ worth of improvements to raise the value of the real estate. The finished renovations would constitute real estate, and you would then be able to the property for one hundred thousand dollars, fulfilling the requirement that the two properties be of equivalent value. the majority of sellers, however, will not be very enthusiastic to perform these improvements so that you can make a 1031 exchange.

In the 2nd, more likely scenario a qualified intermediary who is holding your funds can buy the replacement property from the seller and take title to it in a limited liability company, intermediary-owned company. The intermediary would then use the remaining proceeds to construct the necessary renovations on the piece of property. Upon completion, the intermediary returns the property to you, which then permits you to complete the exchange .

Returning to the previously mentioned $10,000 replacement property: the intermediary who was holding your funds would buy the aforementioned piece of real estate at the asking price and would make the necessary renovations with the remainder of the funds, returning the replacement property to you when the value of the property is high enough to establish likeness with the relinquished property.

Although a Build-to-Suit exchange can help you acquire the replacement property that is right for you, it is key to consider the amount of time required for the improvements that you would like to construct on your property. You have only 180 days in which to bring your 1031 exchange to completion, so it is important to be conscious of what work can actually be finished in this time span. Be mindful that a renovation represents real estate when it is completed, and so work in the process of construction doesn’t add to the property’s value. Though you may not be able to modify your property as extensively as you might want, one hundred and eighty days is plenty of time to complete considerable improvements, and to bring your replacement property that much closer to the property of your dreams.