1031 Exchanges - A Basic Introduction
Broadly speaking a 1031 exchange (also called a Starker) is a swap of one investment property for another. Although most swaps are taxable as sales, if yours meets the requirements of 1031, you'll either have no tax or limited tax due at the time of the exchange.
The biggest advantages of the 1031 simply explained is Depreciation Recapture, and the Delayed Gain.
In effect, you can change the form of your investment without (as the IRS sees it) cashing out or recognizing a capital gain. That allows your investment to continue to grow tax-deferred. There's no limit on how many times or how frequently you can do 1031. You can roll over the gain from one piece of investment real estate to another to another and another. Although you may have a profit on each swap, you avoid tax until you sell for cash many years later. Then you'll hopefully pay only one tax, and that at a long-term capital gain rate some time down the track. There are also ways you can use 1031 for swapping vacation homes—more on that later—but this loophole is much narrower than it used to be.
There are two key timing rules you must observe in a delayed exchange.
The first relates to the designation of a replacement property. Once the sale of your property occurs, the intermediary will receive the cash. You can't receive the cash, or it will spoil the 1031 treatment. Also, within 45 days of the sale of your property, you must designate replacement property in writing to the intermediary, specifying the property you want to acquire. The IRS says you can designate three properties so long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.
The second timing rule in a delayed exchange relates to closing. You must close on the new property within 180 days of the sale of the old. Note that the two time periods run concurrently. That means you start counting when the sale of your property closes. If you designate replacement property exactly 45 days later, you'll have just 135 days left to close on the replacement property.
As always be sure to get good tax and legal advice on suitability for a 1031 exchange. Your accountant or financial advisor is a great place to start as always, and make ensure that if any confusion ensure that your exchange qualifies from a legal perspective. If you don't have these partners we can make a referral as well as the qualified intermediary needed to close most exchanges.