A 1031 exchange refers to Section 1031 of the Internal Revenue Code. This section allows investors to defer capital gains taxes that would be owed on the sale of investment property. The essential elements of the procedure are:
The investor must reinvest the entire proceeds from the sale of the “relinquished” property, not just the gain. For example, suppose you own an office building you bought for $2 million a few years ago. Suppose you now want to sell the building and invest in multifamily housing, and the office building is valued at $3 million. Ordinarily, you would pay capital gains taxes on the $1 million appreciation. In a state with capital gains taxes, you would also pay taxes due at the state level. However, Florida has no state income or capital gains taxes.
If you sell the property and reinvest the $3 million in another property, you can defer payment of the taxes.
- You have 45 days following the sale to formally identify potential replacements for the relinquished asset and must follow the IRS’ rules about identification.
- You must engage a Qualified intermediary to hold the proceeds since you cannot have practical access to the money during the transaction period. The Qualified Intermediary (QI) also maintains necessary records and facilitates the purchase of replacement property.
- If you later sell the acquired (replacement) property without executing another 1031 exchange, you will then owe the deferred capital gains taxes plus depreciation recapture. However, if you conduct consecutive exchanges or hold the property until you bequeath it to an heir, the heir will receive the property at the stepped-up value, and no taxes will be due.
- The investor must complete the entire exchange within 180 days of the sale of the original (relinquished) property. The purchase price of the replacement asset(s) must be equal to or greater than the sales price for the asset disposed of.
- Property sold and property purchased must be “like-kind,” which the IRS defines as property held for investment or business purposes. However, any kind of investment property (such as multifamily housing, office, industrial, vacant, retail, and more) qualifies.
Using a 1031 exchange can be an effective means for investors to leverage the appreciation in their assets. The exchange rules are strict, but the reward may be significant, particularly if the property has gained a great deal of value. If the investor continues to use the exchange tactic, they can fully reinvest the accrued appreciation to acquire more valuable property.
How do state laws affect 1031 exchanges?
In states with capital gains taxes, the taxpayer will ordinarily owe capital gains taxes when they sell an investment property. If the investor executes a 1031 exchange, all states mirror the deferral for the capital gain due at the state level.
Only four states have provisions to pursue the deferred funds if the owner later sells the replacement property without completing a 1031 exchange. Those four states have “clawback” rules they will use to levy state capital gains taxes in such scenarios. Investors conducting 1031 exchanges must keep those states apprised of the disposition of relevant assets.
Florida does not have a state capital gains tax, so there are no additional procedures to follow for intrastate exchanges. However, if an investor from another state purchases a replacement property in Florida, the states with clawback provisions will seek the taxes due if the investor later sells.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Hypothetical examples shown are for illustrative purposes only.