What is a 1031 Exchange?
A 1031 exchange is a real estate transaction in which the buyer and seller effectively swap properties in order to avoid paying capital gains tax on the sale.
1031 Exchange Rules and Timeline
For example, let’s assume that John Doe wants to sell his commercial property for $600,000, which he bought for $400,000 as an investment. He knows that selling his property will generate a $200,000 gain that is taxable.
If John does a section 1031 exchange, he can defer this capital gains tax by replacing the property with a “like-kind” property: another property that is similar in nature to the one he is selling. However, if John sells his property and more than 45 days goes by without obtaining a replacement property, John may be subject to the capital gains tax, as well as a state capital gains tax. To speed things up and ensure compliance, he can contact a qualified intermediary and make a qualified exchange accommodation arrangement. The qualified intermediary is similar to an escrow company in that it will transfer John’s property to the buyer and transfer the replacement property to John.
By using a qualified exchange accommodation arrangement, an “accommodation party” holds John Doe’s property temporarily (or it can hold the replacement property temporarily). It is named as principal in the sale of the property and the later purchase of the replacement property.
Why Does a Section 1031 Exchange Matter?
A section 1031 exchange basically allows an investor to defer a capital gain or loss on the sale of real estate if the investor exchanges it for a “like-kind” property. By using a qualified exchange accommodations arrangement, an investor is able to avoid touching the proceeds from the sale of a property before the proceeds are reinvested, thus helping avoid paying any capital gains taxes and assisting in the transaction.