Savvy real estate investors know that the 1031 Exchange is an important tool that, when utilized properly, allows the investor to defer capital gains tax on property that is sold at a gain. So what is a 1031 Exchange? A 1031 Exchange is an exchange of one property (referred to as the “relinquished property”) for another like kind property (referred to as the “replacement property”) under the rules of Internal Revenue Code §1031. In a 1031 Exchange, the investor places the proceeds of a property sale in escrow with a “qualified intermediary.” These funds are then used to purchase the replacement property, and the investor does not pay tax on income gained from the sale of the relinquished property.
The requirements of a 1031 Exchange include: (i) the transaction must be an exchange through a qualified intermediary as opposed to a sale and purchase; (ii) the replacement property must be like kind to that of the relinquished property; (iii) the same taxpayer must dispose of the relinquished property and acquire the replacement property; (iv) both properties (i.e. the relinquished property and the replacement property) must be held for investment purposes or for use in the investor’s business; (v) to defer all tax the replacement property must be greater in value, equity, and debt than the replacement property; and (vi) replacement property must be properly identified pursuant to IRS §1031 within 45 days of the closing of the relinquished property.
While it has been established that a personal residence is not eligible for a 1031 Exchange as it would violate the requirement that the property be held for investment purposes, IRS Revenue Procedure No. 2008-16 has created a safe harbor for property held for productive use in a trade or business or for investment under Section 1031 even though the taxpayer occasionally uses the property for personal purposes. However, the property must meet certain qualifying use standards, which include, for both relinquished and replacement property, minimum requirements for length of ownership and days rented, as well as maximum requirements for days used for personal use. The other key aspect of the qualifying use standards is that the relinquished and replacement properties must be rented at fair market value.
Through proper planning and analysis, real estate investors can leverage the 1031 Exchange to their advantage. However, that analysis and the rules governing it can be quite complex. Therefore, please consult with your legal and tax advisors as you contemplate your next 1031 Exchange.
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Tim Ryan 
