Taxes and Accounting

Questions to ask about 1031 exchanges

When you sell capital assets, consider deferring capital gains taxes by reinvesting the proceeds in another property or asset.

Published: February 22, 2018

Whether your business is growing and requires a larger space or you’ve decided to downsize your current space, selling property is a big step for any business owner. While tax implications of a large asset sale may seem overwhelming, the ability to fully reinvest the proceeds from that sale could potentially help you expand your growing business with new equipment or additional work space and may help drive long-term investment goals.

Depending on your tax bracket, any capital gains realized on the sale of an asset may be subject to tax, leaving you with less money than you may have anticipated — the tax is measured at the time of the sale. But with a 1031 exchange, property owners are able to reinvest the entire amount of their capital gains without those gains being taxed.

What is a 1031 exchange?

“A 1031 exchange, at the outset, is a very straightforward concept,” explains Derrick Tharpe, vice president and Senior Counsel at Wells Fargo. “If a taxpayer has property they currently own, they can sell that property, and if they reinvest the proceeds into a replacement property, there’s no immediate tax consequence to that particular transaction. They can defer any capital gains taxes associated with that sale.”

However, it’s important to know that the replacement property must fit within the like-kind exchange parameters recognized by the IRS.

How does a 1031 exchange work?

When you sell your existing investment property, you’ll want to work with a qualified intermediary (“QI”). Typically, the taxpayer and the qualified intermediary will enter an exchange agreement at the outset of the 1031 exchange. Under the exchange agreement, the QI is designated to receive funds from the sale of the initial asset and will then hold and safeguard those funds throughout the transaction. Finally, a qualified intermediary can consult with you on the implementation of your Exchange transaction to ensure you’re in compliance with Internal Revenue Codes.

How long does the process last?

While the overall exchange process may differ for each transaction, there are specific deadlines that apply to any 1031 exchange. After the sale of an asset, the Taxpayer must identify all potential replacement assets within 45 days. Additionally, the Taxpayer has up to 180 days from the initial sale date — or until the tax filing due date, whichever comes first — to complete the acquisition of the replacement asset. During this exchange period, timing is critical to successfully completing a 1031 exchange.

“The IRS offers no exceptions and no extensions for those deadlines,” says Tharpe. “The only limited circumstance where they have ever offered an exception is where there has been a federally declared disaster that affects the property involved in the exchange.”

How can I use a 1031 Like Kind Exchange?

Recent tax law changes have limited the application of 1031 like kind exchanges to real estate assets only. Additionally, the properties to be exchanged must be like kind to one another, meaning that both properties must be of the same nature, character, or class as defined by the IRS.

According to the guidelines, various types of assets are qualified for an exchange, but you’ll want to note some key points:

  • Most real estate properties are classified as like-kind

  • Property within the U.S. may only be exchanged with other real estate within the U.S.

  • Property outside the U.S. may only be exchanged with other real estate outside the U.S.

Where do I start?

Seeking a qualified intermediary is the first step in processing a successful 1031 exchange. Make sure you work with a high-quality intermediary, such as a bank.

“[What taxpayers are] looking for is security and stability of their funds,” says Tharpe, “which they may not get if they choose a lower quality intermediary.”

At the end of the day, the bottom line is simple: Talk to a tax advisor.

“We get a lot of questions as the intermediary, and we can offer some general guidance for the taxpayer,” says Tharpe. “But, that’s where they really need to turn to their own tax counsel to get information that’s particular to their transaction.”

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