How Does A 1031 Exchange Work

The IRS code 1031 has been around for quite some time now, but still most people misunderstand its provisions. So, how does a 1031 Exchange work?
Section 1031 of the IRC has only a few simple stipulations. If you follow these, you can not only save on your capital gains tax, but also exchange your old property for a bigger one.

The first stipulation states that only two like-kind properties can be exchanged with each other. And, this is where all the confusion generates. The term like-kind refers to the usage of your property. Therefore, if you have been using a factory, an apartment, an outhouse, or anything else, for your business, trade or investment, you can exchange it for another, which has been used in a similar fashion.

Mostly, people misunderstand this stipulation for the grade, character and quality of the property they want to exchange. This is, however, a totally wrong understanding.

But first, to be considered for deferred tax treatment, your property must qualify as such. As already partly discussed, earlier, any real estate, including land, must be used for productive purposes and/or investment purposes only. Personal and dealer property do not qualify for a deferred tax treatment.

By personal property, the IRC means those properties, which are used by the owners for their own residential purposes. For example, an apartment, a vacation house, an outhouse, etc. used for your own residence. However, if a residential property is rented out throughout its usage period, it will qualify under this section.

Another exception is the case of a residential property purchased mainly to be sold at a higher price in the future. This is classified as a property used for investment or speculative purposes. Section 1031 allows for tax savings on the sale of such properties also.

The IRS has appointed qualified intermediaries throughout the country who must be appointed by you to conduct a 1031 Exchange. Immediately after selling of your qualified property through a real estate agent, you must appoint your intermediary.

The intermediary will ask you to fill up a form and then keep the proceeds from your sale in a specified bank account. He will then help you to locate the right like-kind property. Two time limitations have also been specified by the IRS, in order to avail the benefits of this provision.

You must locate your new property within 45 days of closing your sale. And within 180 days of such closure, your new property must be in your legal possession. Another thing that you must keep in mind is that your new property must be of the same, or of a value higher than what you just sold.

The final step in the discussion of how does a 1031 Exchange work is to fill up the required IRS form and submitting it as soon as possible to the right authorities.

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