Investors preparing for the sale of a property held for business or investment purposes should consider a 1031 exchange . Internal Revenue Code Section 1031 allows real estate investors to defer costly capital gains and recapture taxes by reinvesting in like-kind real estate. Utilized properly, 1031 exchanges provide investors with substantial tax deferral that allow them to shelter the growth of their wealth and keep more of their money working for them.

In a typical property sale, the seller must pay taxes on the capital gains realized as well as on the prior depreciation that was utilized to defer taxes on the property's income. These capital gains and depreciation recapture taxes can exceed 20-30% of the gains realized upon sale. If a 1031 exchange is utilized, the burden of capital gains and depreciation recapture taxes can be deferred, allowing an investor to potentially build wealth through income and appreciation on reinvested capital that otherwise would have been lost to taxes.

1031 Exchange Rules

The IRS outlines several rules that must be followed for a transaction to qualify for tax deferral through a 1031 exchange. Rules address which types of real estate can be utilized for an exchange, how proceeds from the sale of the relinquished property must be handled throughout the exchange, how and when replacement property must be identified, and required timelines for closing on the replacement property.

1. There are three essential rules of a 1031 exchange:

2. The investment properties exchanged must be the same in nature and character (" like kind ").

3. The value of the replacement property must be equal to or greater than the value of the relinquished property to obtain a full deferral.

The title of ownership on the replacement property must be the same as on the relinquished property.

Which Properties Qualify for a 1031 Exchange?

According to IRC Section 1031, both the relinquished and the replacement properties must be held for investment purposes, and they must be "like-kind" properties. Property held for investment purposes can include a multitude of real estate types, but most are rental properties or commercial real estate. Personal residences and vacation homes that are not utilized primarily as rentals do not qualify for a 1031 exchange. "Like-kind" simply refers to the fact that investment real estate must be exchanged for investment real estate. In other words, investment real estate cannot be exchanged for stock, debt, or other investments in a 1031 exchange. Also, a 1031 exchange applies only to real estate located in the United States.

Utilizing a Qualified Intermediary (QI)

If an investor takes constructive receipt of the proceeds (cash) from the sale of the relinquished property, a 1031 exchange cannot occur. The Treasury provides safe harbor guidelines that allow an investor to use a Qualified Intermediary (QI) to avoid taking constructive receipt of the funds in an exchange transaction. A QI is any independent party that facilitates tax-deferred 1031 exchanges in accordance with IRS section 1031. The QI utilizes the funds from the sale of the relinquished property to purchase the replacement property. The QI must be independent and cannot be the investor, relatives of the investor, or any person deemed to be under direct control of the investor.

Replacement Property Identification Guidelines

The IRS outlines three ways that replacement property can be identified: the 3-Property Rule, the 200% Rule, and the 95% Rule.

• 3-Property Rule : Allows an investor to identify up to three potential replacement properties and close on any or all of them to complete the exchange.

• 200% Rule : Allows any number of properties to be identified as long as their total value does not exceed twice the value of the relinquished property. As in the case of the 3- Property Rule, once identified, any or all of the potential replacement properties can be purchased to complete the exchange.

• 95% Rule : Allows an investor to identify an unlimited number of properties, but the investor must purchase 95% of the aggregate fair market value of all of the properties identified.

1031 Exchange Time Limit ("Exchange Period")

The most important deadlines for a 1031 exchange are the identification and closing dates. Weekends and holidays are included in the deadlines. Investors must adhere strictly to the timeline in order to complete a successful 1031 exchange.

• 45-Day Rule : Within 45 days of the close of escrow for the relinquished property, an investor must identify any replacement property that will be purchased to complete the exchange.

• 180-Day Rule : Within 180 days of the close of escrow for the relinquished property, an investor must close on the purchase of the replacement property identified to complete the exchange.

Putting It All Together: How a Typical 1031 Exchange Works

The IRS outlines several different types of exchanges that allow for the deferral of capital gains and depreciation recapture taxes, but the most common is the delayed exchange. In a delayed exchange, the investor sells a rental property. The proceeds are held by a QI. The investor then has 45 days from the close of escrow to identify a replacement investment property and 180 days from the close of escrow to close on any identified property. After the investor identifies the replacement property or properties, the funds held with the QI can be utilized to purchase and close on the replacement property. The investor then takes title of the replacement property, and the 1031 exchange is complete.

Other Considerations

Boot: In order for a 1031 exchange to defer the entire tax burden, all of the equity proceeds from the sale of the relinquished property must be reinvested in the replacement property. Any part of the proceeds of the relinquished property sale (whether cash or mortgage) not utilized or sheltered in a 1031 exchange is considered "boot" and subject to capital gains and depreciation recapture taxes.

Inheritance Benefits - A Step Up in Basis

Capital gains and depreciation recapture taxes can be deferred indefinitely through the use of 1031 exchanges. This tax burden can be avoided permanently through a "step up in basis," whereby heirs inherit property and realize a basis adjustment to the current market value as of the date at death or alternate valuation date. Heirs realize gains and taxes on sales only on those gains above this new, potentially higher valuation. Additionally, the heirs receive a new depreciation schedule, which can be utilized to shelter the property's income from taxes.

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This article originally appeared on ExchangeRight's website.