We believe it is important for our clients to understand the process they are about to go through before they actually begin. For this reason, we offer details about a series of exchange basics on this page and a wealth of other reference materials on our site.
A 1031 Exchange is an IRS-authorized process where like-kind business or investment property is exchanged without immediate tax liability to the property owner (Exchangor).
The IRS requires a neutral third party, known as a facilitator, qualified intermediary (QI) or accommodator to be used for facilitating the 1031 Exchange.
Why Consider An Exchange?
As a property owner or business owner, the 1031 Exchange is a powerful investment tool.
Property that is sold or transferred for gain can be subject to taxation. Those taxes can add up quickly depending on the type of property, how long it was owned, state taxes, capital gains, depreciation and the owner’s tax bracket. As a property seller, you may be liable for taxes that add up to 40% or more.
A 1031 Exchange gives the Exchangor the ability to keep all of the property’s equity for re-investment, allowing the Exchangor the opportunity to acquire a replacement property with better cash flow, less management, a more desirable location and other such investment goals.
Property held for productive use in a trade, business or for investment may be exchanged for like-kind property. For real estate, like-kind property is widely defined as real property located in the United States and some of its territories. A single-family rental can be exchanged for a duplex, raw land for a shopping center, or an office building for apartments. Any combination will work.
Real property and personal property are not like-kind to one another. A commercial building may not be exchanged for an airplane, a single-family rental for a licensed timeshare, or raw land for heavy construction equipment.
Personal property is evaluated based upon its nature and character, its General Asset Class, and NAICS classification. A school bus may be exchanged for a metro bus, a barge for a tugboat and a fleet rental car for a taxi.
What Does Not Qualify?
In 1986, the IRC 1031 was revised to exclude some property interests from being exchanged. These property interests include: a personal residence (although the portion of the residence that qualifies for business or investment use—i.e., a home office—may be exchanged), stock in trade, stocks, bonds, notes, securities or other evidence of indebtedness, partnership interests and the goodwill of a company.
Property held primarily for sale is also excluded. Examples of real property that may fall within this category include: developed lots, property held for resale, property sold immediately after acquisition or completion of improvements, speculation homes and fixer-type properties that are not rented out. Examples of non-real property include business inventory, such as cars for a car dealership or computers by a computer manufacturer.
Although IRC 1031 does not address vacation homes (or second homes), Revenue Procedure 2008-16 provides that vacation homes may qualify depending on the Exchangor’s use and tax treatment of the property.
We believe that you should understand the real estate exchange process before you go through with an improvement exchange or any other sort of exchange. This is why we listed a variety of exchange basics on this page.