Understanding the 1031 Exchange Process: Part 2
Check out part one of 1031 Exchange: How Does That Work? To recap: when selling commercial property, taxes are usually paid on the profits at the time of sale. But, IRS Section 1031 is an exception allowing the seller to postpone paying tax on those profits if they are reinvested in similar property.
(It’s important to note that profits deferred in this sort of like-kind exchange are tax-deferred, not tax-free.)
What’s the benefit? A seller can transfer the equity in their current investments into a like-kind property that may have a stronger tenant with more credit, a higher return on investment – or both. The definition of “like-kind,” according to the IRS, means any class of real estate can be exchanged for any other type of real property. The caveat is, property used for personal use does not qualify as like-kind.
COMMERCIAL REAL ESTATE DEFINEDIn a 1031 exchange, the property sold is commonly referred to as the “downleg” and the property(ies) purchased with the proceeds is called the “upleg.”
Timing Rules
While the property exchange rules are complex, the rules for timing a 1031 exchange are fairly straightforward. At closing of the downleg property, the proceeds are escrowed with a 1031 exchange accommodator (also known as a Qualified Intermediary). The seller then has 45 days to identify one to three properties to potentially buy. These are the upleg properties.
The next step is closing on the upleg property(ies). Closing must occur within 180 days of the sale of the downleg property. At least one of the identified properties must be purchased. If the proceeds from the downleg are not all reinvested on the upleg property, then any difference in price is taxable as a capital gain.
Careful planning is key in meeting the 1031 exchange rules. Determining viable upleg opportunities prior to the closing of the downleg property is strongly recommended. Understanding the market and selecting a suitable upleg can be an early step in the process to minimize risk.
Interested in reviewing potential upleg properties in Montana? Contact Matt Mellott.
