1031 Exchanges

In real estate, capital gains tax is normally due on the seller’s gain when selling investment property. The gain is the difference between the basis and the sales price. The basis is the purchase price from when the seller purchased the property, plus any amount spent for improving the property.

For example, if an investor paid $100,000 to purchase property and later sold it for $150,000, capital gains tax would be due on the $50,000 gain.

1031 exchanges are used by real estate investors to delay or avoid paying capital gains tax on the sale of real property.  It is normally not used for primary residences because there are other tax exemptions for the sale of a primary residence. 

Basically, a 1031 exchange is when the owner sells real estate and uses those proceeds to purchase up to three other properties.

The funds are held by a Qualified Intermediary and must be used to purchase ‘like kind’ property. When selling, the owner never has access to the sales proceeds because the funds are sent to the Qualified Intermediary.  If all the funds are not used for another purchase, the owner would have to pay taxes on the funds not used. The Qualified Intermediary will send the funds to the closing attorney or title company for the purchase of the new property. 

The property being purchased must be ‘like kind.’ The IRS has a fairly loose definition of what ‘like kind’ means.  The purchased property does not need to be exactly like the property sold.  Almost any investment property will be considered ‘like kind.’ The quality of the property does not matter at all either. Almost any real property will be considered investment property if it is being held for an investment. Vacant land can be exchanged for a strip mall as long as it is being held as an investment and not being developed.  

The closing process is not much different from a regular closing. The only difference is that the funds are either sent or come from the Qualified Intermediary.  The individuals still sign all the closing documents the same as they would in a regular closing. The Qualified Intermediary will also need to sign the closing statement in most transactions.  

The sale and purchase are not taxable events when using a 1031 exchange. The Qualified Intermediary will charge fees to hold the funds and create the forms required by the IRS. The actual closing costs will be the same except for the Qualified Intermediary fees. It is an easy tool to delay or avoid capital gains taxes when selling investment real estate.

John C. Bennett is a real estate closing attorney and owner of Origin Title and Escrow, Inc.. Since 2003, Origin Title has handled real estate transactions – purchases, refinances, reverse mortgages – quickly and professionally. There will be no surprises, nothing misunderstood. Title searches are thorough and well-reasoned, to avoid unpleasant surprises later down the road. Calculate your closing costs in Georgia or Florida using our calculator or contact Origin Title using this form.