Blog Index

Selling an Investment Property: The 1031 Exchange

Posted on 24th May 2016

When the owners of investment properties sell, they are typically required by the Internal Revenue Code to pay taxes on the profit they gained from making the sale, but Internal Revenue Code Section 1031 creates an exception to this general rule that enables sellers to defer taxes by reinvesting to exchange the property with another property of a similar type also used for investment purposes. 

Real estate investors are drawn to the 1031 Exchange for the obvious tax benefits of deferring taxes to a future date, when the replacement property is sold and not as part of another exchange. Owners are then liable for taxes on "the original deferred gain, plus any additional gain realized since the purchase of the replacement property." Thus, it is important for those engaging in an exchange to make an accurate determination of the basis of the property. According to the Internal Revenue Service, basis is the amount of capital investment in a property.

It is important to have several different experts on hand to manage these complicated transactions, including the attorney who will handle the sale and an accountant. The IRS imposes strict requirements on those who would seek to make the exchange. Those who are relinquishing their properties have 45 days from the date of sale to identify potential replacements, and the seller of the new property — or a qualified intermediary acting on behalf of this seller — must receive this identification in writing. A qualified intermediary might be a real estate broker. Moreover, their are strict deadlines and timelines involved in an exchange.

If cash is exchanged prior to the conclusion of the exchange, it might pose a risk that the transaction is disqualified as a like-kind exchange. Those making an exchange should "use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete." As real estate brokers often hold proceeds for buyers and sellers in escrow, they are an ideal choice for holding any proceeds.

In New York City, there are real estate brokers that specialize in these types of transactions, so sellers should be aware that they might want to list their properties as being available for an exchange. An ideal situation might be one in which two sellers exchange their properties, with both gaining the tax benefits. Because the property can't be used for non-business purposes, the property should be used exclusively for investment purposes and not as the owners' primary residence.