Section 1031 of the Internal Revenue Code allows owners of appreciated business or investment real estate to sell their property, purchase a “like-kind” property as defined under IRC 1031, and completely defer the capital gains tax otherwise due upon sale. It works like this:
In order for the transaction to qualify for favorable tax treatment, the property owner must retain a Qualified Intermediary (QI) to ensure that the sale of the original property and purchase of the replacement property are structured properly under the 1031 exchange rules. A QI is typically a title company, escrow company or bank trust company. After the property owner finds a purchaser for their property, they need to establish a 1031 exchange escrow account with the QI. When the original property is sold, the funds must be transferred into the 1031 escrow account. The property owner CANNOT be in constructive receipt of sales proceeds.
Once the original property is sold and the sale proceeds are deposited into the escrow account held by the QI, the property owner has 45 days to identify replacement property and 180 days to purchase the replacement property.
Property Identification Rules
Under the property identification rules the property owner can identify replacement property under any of the following conditions:
- 3 Property Rule: Up to three properties can be identified with no cap on the total value
- 200% Rule: Any number of properties can be identified as long as the total value of the properties does not exceed 200% of the value of the original property
- 95% Rule: Any number of properties can be identified, but the property owner must purchase 95% of the properties identified
“Like-Kind” Property
The IRS defines "like-kind" property as any real property held for business or investment purpose. This definition includes commercial property, rental property, farmland and undeveloped land. The IRS makes no distinction between asset types, so there is no need for the property owner to acquire the exact same asset type to defer the capital gains tax. For example, an investor who sells farmland can acquire a commercial office building and that would qualify as “like-kind” under the IRC 1031.
Debt Requirements Under IRC 1031
A property owner who has debt on the original property must purchase replacement property for equal or greater value and place equal or greater debt on the replacement property. Alternatively, if the property owner pays off debt on the original property, and adds cash into the 1031 account equal to the amount of debt paid off, the property owner will defer all capital gains tax. The key is that the property owner must purchase replacement property of equal or greater value to defer all capital gains tax.
Clients and prospective clients of Welsh Securities, LLC should not construe the contents of this website or any prior or subsequent communications from Welsh Securities or its respective affiliates as legal or tax advice. Each individual investor should consult his or her own counsel, accountant and other advisers as to tax matters concerning such person's investments.
There are unique risks associated with owning commercial real estate that apply to investors utilizing IRC 1031 and/or IRC 721. These risks include, but are not limited to, loss of property value, real property assets being highly illiquid, risks associated with the general economic climate, local real estate conditions, the markets for leasing, geographic or market concentration, the abilities of managers of the assets and loss of management control in some tenant in common situations, and the use of mortgage financing which creates risk related to fluctuations in interest rates and foreclosure. Additionally, real estate investments may be subject to fees and expenses that impact the performance of the investment, including but not limited to, property management, asset management, financing, brokerage, or facilitation fees.
Privacy Policy | Business Continuity Plan Disclosure
