If you represent a business that buys and sells property with any regularity, or an individual that does the same, you are familiar with the consequences of capital gains taxation. This tax, assessed on the difference between the price an asset is purchased at and what it is sold for, can take a big bite out of the gains. In fact, capital gains as a form of taxation has been widely, and at times wildly, debated, with some calling it unfair form of double-taxation.
That being the case, the tax exists today. However, there is a provision in the tax code that allows taxpayers to avoid capital gains, at least in the near-term. The so-called 1031 Exchange allows taxpayers to exchange one property for another and in so doing defer capital gains.
The rules governing these exchanges are relatively complicated, but they are worth understanding. The first place to start is by understanding the Qualified Intermediary (QI). A QI is required in this process. QIs serve as a third-party, who holds the funds from the sale of the first property (the relinquished property) until they can be used to purchase the second (or replacement) property. There is no way around this; it is part of the tax code, so QIs must be used in order for the transaction to qualify for the tax benefit.
Next, the concept of like-kind must be understood. The IRS regulations pertain to the exchange of like-kind properties. So, for example a piece of commercial property could not be exchanged for a piece of raw land and still qualify for the tax benefit. It must be exchanged for a piece of commercial land. Second, the definition of like-kind is slightly different, depending on whether you are a business or an individual. The definition of like-kind for a business does not account for the class or grade of the property; it does in the case of individual properties.
All the above pertains to various different types of exchanges. The code was devised to work in cases where the taxpayer sold an existing property and then purchased a replacement property. But not all transactions occur in this order. There is also what’s called a “reverse” exchange, where the order is reversed.
There are a couple of important things to understand about this type of exchange. First, as the name implies, it pertains to situations where the replacement property is purchased before the relinquished property is sold. Many people prefer this order because it takes the risk out of having to find a replacement property within the 45 days allowed by the code. That said, there are still time-based requirements associated with these transactions. The relinquished property must be identified within 45 days and it must be sold within 180 days of the acquisition of the new property.
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