What is a Tax-Deferred 1031 Exchange?

Normally when an investor sells a real estate holding for a gain, capital gains tax is due in conjunction with the sale.  A 1031 exchange in real estate, sometimes known as a 1031x or tax-deferred exchange, offers investors the opportunity to defer payment of capital gains taxes on the gain on a sale of an investment property under certain conditions.   Use of a 1031 exchange enables investors to keep a significantly greater amount of their capital invested and generating returns, since payment of tax liability is deferred.

While simplified, illustrates the power of a 1031 exchange.  The ability under the tax law to defer payment of taxes enables an investor to have more capital invested than he or she would otherwise, and therefore enables higher returns on investment.
A 1031 exchange is fairly straightforward to accomplish.  Section 1031 of the Internal Revenue Code lays out the guidelines that must be followed to execute a 1031 exchange.   While there are a number of categories of assets that can be transacted under a 1031 exchange, the information that follows pertains only to real estate investment property.

Key Timeframes for a 1031 Exchange


 

There are two important timeframes: the identification period and the exchange period.

Identification period. During the identification period, the investor has exactly 45 days from the date his or her relinquished property has sold to identify in writing the replacement property or properties to be purchased. Identification usually consists of an address and/or legal description.  There is no extension of the 45 day deadline under any circumstances.

Exchange period. The exchange period is the timeframe in which the investor must receive (close escrow) on the replacement property.  This period ends at exactly 180 days after the date on which the person receives the relinquished property or the due date for the person’s tax return for that taxable year in which the acquisition of the relinquished property has occurred, whichever occurs first. In the latter instance, an investor can always file for an extension on his or her tax return, in which case the exchange period would still be 180 days.

Violation of either the identification or the exchange periods will result in the invalidation of the 1031 exchange, and the investor must pay the taxes due on the capital gain.  Therefore it is important for the investor to not wait until the last minute to either identify or close escrow on the replacement property.  Usually the greater risk is with the exchange period, as financing is often involved in the purchase transaction, and delays related to the lender are commonplace.  Although it can be done faster, investors should allow up to six weeks to obtain financing for their replacement properties (and longer for commercial properties).

For Key Concepts & Definition of a 1031 Exchange Click Here.

About the author:  Kevin Conlon is co-founder of Meridian Pacific Properties, Inc., a provider of real estate investment property.  He has invested in single-family residential property continuously since 1981.