The 1031 Tax Deferred Exchange is one of the last tax shelters allowed by the Internal Revenue Service. It is a transaction in which a taxpayer exchanges investment property for like- kind investment property, and defers the payment of capital gain taxes. The IRS defines like-kind property as all real property held for investment purposes, or the productive use in a trade or business. This basically includes any real estate held for investment except your primary residence and second family home.
There are some important rules which must be followed to effectuate a valid exchange:
- The exchange must be opened before the close of Escrow on the relinquished (sale) property.
- The taxpayer must identify the replacement (acquired) property within 45 days after the close of the relinquished(sale)property.
- The taxpayer must close Escrow on the replacement property within 180 days from the close of the relinquished property, or, before the date the tax return filing is due for the tax year in which the relinquished property was transferred – whichever comes first.
- The taxpayer must reinvest all net proceeds into the replacement property.
- The taxpayer must obtain a debt of equal or greater amounton the replacement property.
By following these rules, the taxpayer shelters capital gains tax into the replacement property,and defers the recapture of depreciation tax. This creates more buying power for the taxpayer than if the capital gains tax was paid. Also, by deferring the payment of capital gains tax, the taxpayer gets to invest the taxes into the replacement property interest free from the IRS. The 1031 Tax Deferred Exchange also avoids the California Withholding Tax.