An IRS 1031 exchange is a provision in the Internal Revenue Code that allows the owner of investment real estate to sell that property and to use the proceeds of the sale to purchase another investment property without paying capital gains taxes.  There are specific requirements that must be followed for an investment property owner to qualify for a 1031 exchange. These requirements regulate items such as:

  • The time frame in which the sale and purchase transactions must occur;
  • The types of properties that can be used in the transaction;
  • The amount of debt encumbering the properties; and
  • The use of third party intermediaries. 

If the transaction is properly executed, this tax free exchange can save an owner a significant amount of money equal to roughly 15%-25% of the sales price they receive from the sale of the initial property.  With depressed real estate values stemming from the downturn in the real estate market, many investment property owners may think that their property is no longer a candidate for a 1031 exchange.  However, depending upon the individual situation this may not necessarily be the case. 

This is because the IRS defines a “gain” as the difference between the adjusted sales price of the property and the owner’s basis in the property.  Typically the owner’s basis in the property will be the original purchase price of the property less depreciation taken.  Depending on the amount of depreciation taken, the owner could recognize a “gain” upon the sale of the property even if they sell the property for the same or even less than they originally paid for it.  Therefore, the market downturn does not necessarily mean you don’t have a gain.  If you do find that you have a gain on your investment property, the property may be a good candidate for a 1031 exchange. 

When considering the viability of a potential 1031 exchange, you should first determine if both the property you are selling and the property you propose to buy qualify as “investment” properties.  Are or will these properties be held for investment or business purposes?  If you are in the process of selling your investment property and have not yet identified an adequate replacement property to purchase, will you be able to identify an adequate replacement property within 45 days of the sale of the property and will you be able to close on the replacement property within 180 days?

However, the most important question that you need to ask even if you can qualify for a 1031 exchange is does it make economic sense to do so?  With capital gains tax rates at relatively low rates and a depressed real estate market, now may be the perfect opportunity to cash out of your investment property, pay the capital gains and reset your basis in future properties.  Determining whether a 1031 exchange makes economic sense will depend upon your particular investment goals and the financial circumstances specific to your investment property.

If you would like more information regarding 1031 exchanges or to discuss whether a 1031 exchange may be right for you, please contact our Business Law Group partner, David A. Closson at [email protected].

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