In the mortgage industry you will hear quite often about the section 1031 exchange, it is recognized as the tax-deferred exchange or real estate exchange, was created in 1990 by the I.R.S.
A Section 1031 exchange is the process of selling one real estate investment for the purchase of other real estate investments.
When used with a mortgage, homeowner's will usually sell one of their real estate investment holdings to purchase some other, comparable property, they can then offset or straight out avoid capital gains tax.
The real estate property or properties which are sold is called a "released property" and the property acquired is called "replacement property”.
Before the introduction of the 1031 exchange, a homeowner had to sell one place ahead of the close of escrow on the new property, a practice which proved to be very difficult.
The I.R.S. ultimately advised a solution with the introduction of the 1031 exchange, which in effect allows a homeowner to sell the released property, payoff the existing mortgage and apply the proceeds to buy the replacement property later.
In order for the exchange to work properly, it has to be overseen by a qualified intermediator and certain rules must be adhered to.
Real estate is divided into four categories, including property obtained for business purposes, investment property, personal property , and property held principally for sale. The first two allow for a 1031 exchange, while the last 2 do not.
All proceeds from the released holding sale must be invested in the replacement property. The exchange of properties needs to be of like-kind, meaning that classification of the properties is the same, and not established on their quality or condition.
There are also certain section 1031 requirements that must be rigorously observed. The designation period starts the date the relinquished property is transferred and expires after 45 days.
The exchange period begins on the date you transfer the relinquished property and ends after 180 days or earlier if tax returns for the taxable year are submitted before those 180 days.
There needs to be an actual exchange, supervised by a qualified intermediary, and not just a reassign of property for money only. It’s always wise to look for the services of a professional early on to avoid any expensive errors when executing a section 1031 exchange.