This IRS tax rule can help owners save on capital gains taxes by reinvesting in their business.
Selling a building, property, or other business-related real estate is a big step for any business owner. While tax implications of a large real estate sale may seem overwhelming, understanding Section 1031 of the Internal Revenue Code can help you save money and build your business. You just need to make sure you reinvest the proceeds appropriately. Learn more about how a 1031 exchange works, what properties qualify, and who can help you navigate the process.
What is a 1031 exchange?
A 1031 exchange is a tax-deferred transaction. If a business owner has property they currently own, they can sell that property, and if they reinvest the proceeds into a replacement property, they can defer any capital gains taxes associated with that sale.
This formerly applied to other types of business assets, but changes to the tax code now limit its application to real estate assets. Still, there are rules regarding what types of real estate qualify and the required timeframe of the transaction.
What types of properties qualify?
To qualify as a 1031, both properties involved in the exchange must be “like-kind,” meaning they must be of the same nature, character, or class as defined by the IRS. For example, you could exchange a vacant lot for an apartment building, or swap a strip mall for an industrial warehouse as long as both are used for investment or business (PDF).
A few key points to know:
- Primary residences and second homes don’t qualify.
- The replacement property must be of equal or greater value.
- All equity must be reinvested to defer taxes.
- A property within the U.S. may only be exchanged with other real estate within the U.S. A property outside the U.S. may only be exchanged with other real estate outside the U.S.
How does the process get started?
To defer capital gains taxes with a 1031 exchange, you must follow strict IRS rules. One of the most important is how the sale proceeds are handled. You can’t receive the funds directly, even temporarily, or the transaction doesn’t qualify as a 1031 exchange.
When you sell your existing investment property, you’ll need to work with a qualified intermediary (QI). A QI may be a well-established QI firm, a CPA with 1031 experience, or a real estate attorney. Typically, before the relinquished property is sold, its owner and the QI will enter into an exchange agreement that designates the QI to receive and hold the sale proceeds. The QI ensures the funds are used only for the purchase of the replacement property. A QI can also guide you through the timeline and documentation to stay compliant with IRS rules and help prevent costly missteps.
When must the transaction be completed?
While the overall exchange process may differ for each transaction, there are specific deadlines that apply to any 1031 exchange. After the sale of the relinquished property, the business owner must identify all potential replacement assets in writing within 45 days. They then have up to 180 days from the sale date of the original asset (or until the tax filing due date, whichever comes first) to complete the acquisition of the replacement property. Missing either deadline means the exchange doesn’t qualify for tax deferral and is treated as a standard sale in which the owner may be liable for capital gains taxes on the sale of the original property.
Where do I start?
Seeking a QI is the first step in processing a successful 1031 exchange. Make sure you work with a high-quality intermediary. There is no regulation over QIs so using someone with experience and knowledge is important.
As you make big decisions about your business, make an appointment with a Wells Fargo banker who can provide products and services designed for your needs.
