Understanding 1031 exchanges is important if you plan on buying and selling similar properties that are used for business.  The reason it’s important is because it can save you a lot of capital gains taxes.  There’s no one who wants to pay more taxes than is necessary, and there’s only one way to make sure you are keeping your taxes as low as possible on this particular kind of transaction.  You have to know the rules so you can play by them.

The 1031 tax exchange is named after the section of the US Tax code called…guess what?  Yes…section 1031.¹  If you follow the guidelines of this section, you can defer capital gains taxes.  The exchange of property has to be between properties used for business or as an investment.  In other words, you can’t use a 1031 exchange on residential properties which are used as primary residences.  You could use it though when you sell an apartment building and then buy another apartment building.  The properties have to be what is called “like kind”.

When the exchange occurs between like kind properties, the gain or loss is not recognized. If you do an exchange that includes property that is not like kind, then you will have to recognize the gain attributable to that portion of the exchange.  The loss, though, is not recognized. 

There are some twists to this regulation of course.  You don’t expect the IRS to have a simple regulation without exceptions and qualifications, do you?   For example, you can use the money you get from selling one property to buy one or more properties that are like kind.  You can’t use the sales of investment property to buy a personal residence though and get to use the 1031 exchange.²

The person taking advantage of the 1031 tax exchange must use a qualified intermediary.  The intermediary handles the money and makes sure the money exchange is properly accounted for.  The IRS is going to make sure they get their due!

There are time limits on when all of this can take place.  You can’t sell a business property and then sit on the money for weeks.  You have 45 days to let the qualified intermediary know what property you are buying as part of the exchange.  Then you have 180 days to finish the exchange by buying the new business property. 

You can save a lot of capital gains taxes on the 1031 exchanges.  The key is to make sure you follow the IRS rules.

Sources:

1.http://www.irs.gov/businesses/small/industries/article/0,,id=98491,00.html

2.http://www.finweb.com/taxes/the-1031-tax-exchange.html