If an investor sells appreciated property they pay tax. However, property that qualified for preferential tax treatment under Internal Revenue Code Section 1031 (IRC§1031) is treated quite differently. IRC §1031 states:
“No gain or loss shall be recognized if property held for productive use in a trade or business for investment is exchanged solely for property of like-kind.”
In 1991, the IRS published specific and clear guidance for the Safe Harbor conduct of Like-Kind Exchanges. This regulation covers the role of the qualified intermediary, safe harbors rules, assignment of contracts, control of escrow funds, identification requirements, earning of interest and who is disqualified to act as a qualified intermediary or control the escrow account. This regulation greatly simplified tax deferred exchanges and has revolutionized the exchange process.
The property currently owned must be held for investment, business or production of income. Like-kind means that in an exchange:
- Any property held as investment or business real estate (townhouse rental, land, farms, etc.) can be relinquished and replaced with any other property to be held as investment or business real estate (office condos, warehouses, vacation rentals, land, etc.) anywhere in the United States.
- There is no similar kind restriction (ie. rental for rental; land for land).
Properties that cannot be exchanged under IRC §1031 rules are:
- A principal residence
- A personal use second home
- Dealer property
It is not important how the property is currently being used by the seller. The property must be identified in 45 days. The property must be settled in 180 days (or the tax due date, including extension, if earlier).
There are three exchange options:
- The Three property Rule: The Investor may identify up to three properties without regard to their value;
- The 200% Rule: The Investor may identify more than three properties. Provided their combined fair market value does not exceed 200% of value of the property sold; and
- The 95% Rule: The Investor may identify any number of properties, without regard to their value, provided the Investor acquires 95% of the fair market value of those properties.