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1031 Exchange Benefits: Protecting Real Estate Investor’s Gains From the IRS During the Sale of Property

Posted on in Real Estate

kendall county real estate lawyerIn 2021, the median value of a home in the state of Illinois increased almost 50% from the median value in 2012. 10 years ago the median home value in Illinois was $157,000. In 2021 Zillow reported that number to be just under $230,000. Now, in 2022, that number has grown over 11% in just one year to over $267,000. The increasing home value is great news for real estate investors and owners of investment properties. However, the IRS (Internal Revenue Service) can and will go after a seller’s gains through taxes. A 1031 Exchange is one way that investors in real estate can avoid certain taxes by the IRS. 

What is a 1031 Exchange?

A 1031 Exchange is a tool that real estate investors and owners of investment properties can use to protect their gains from the sale of property from being taxed by the IRS. 

26 U.S. Code §1031(a)(1) states: no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a “like-kind” which is to be held either for productive use in a trade or business or for investment.

In non-tax law jargon, during a typical sale and purchase of real estate a seller must pay the IRS a number of taxes specifically related to the sale of the property. These taxes include capital gains tax, depreciation recapture tax, and net investment income tax. A seller can avoid paying these taxes to the IRS using a legitimate and proper 1031 Exchange. The process allows property owners to avoid paying capital gains taxes by reinvesting the earnings that are gathered from the sale of real estate. Real estate investors and owners of investment properties that are concerned about their tax liability should seriously consider the benefits of a 1031 Exchange.

Most Common 1031 Exchange: Real Estate

There is more than one type of 1031 Exchange and each type carries their own specific requirements and limitations. The most common type is that used for real estate exchanges by real estate investors and owners of investment properties. The reason 1031 Exchanges are most commonly used for the sale of real estate is likely a result of the broad definition of what is considered “like-kind” for real estate exchanges. In general, any type of real property located in the United States that is held by the owner for productive use in a trade or business or for investment purposes can be exchanged for more real property, so long as the properties are of “like-kind.” Real estate and tax law can be complex and errors made in the process can subject an investor to very real legal penalties. For this reason, the importance of having a qualified, experienced professional to assist with the process of a proper 1031 Exchange cannot be emphasized enough. 

What Does a 1031 Exchange Entail?

A 1031 Exchange involves the seller of real estate acquiring new real estate at the time of the sale. Due to the 1031 Exchange, the IRS recognizes the transaction as an exchange of a relinquished property for a replacement property rather than as a sale and purchase of real estate, allowing the seller to avoid the above mentioned taxes applied by the IRS to the typical sale and purchase of property.

Overview of a 1031 Exchange

The sale and purchase of real estate comes with a number of requirements and deadlines. It is critical to follow certain specific steps when deferring your taxes with a 1031 Exchange. A quick overview of the 1031 Exchange process includes the following: first, your attorney will ensure that the property in question that is being sold (the original property) is an income-producing property, as is required for this specific tax benefit. Second, your attorney will ensure that the property that will be “exchanged” (the replacement property) is a qualified “like-property” under the law. Additionally, the value of new property (or properties) must be of same or higher value than the original property otherwise the proceeds will be taxable. Third, your attorney will ensure all timelines and deadlines are strictly followed. Under the law, the replacement property must be identified within 45 days of selling the original property and the close of the second sale must be completed within 180 days after that. Additionally, your attorney will generally recommend using an intermediary to hold the funds from the sale of the original property until they can be reinvested into the purchase of the replacement property, rather than immediately taking the cash from the sale of the original property. 

Experienced, Reputable Real Estate Attorneys in Kendall County

There are specific requirements that must be met to successfully complete a 1031 Tax Deferred Exchange. Hiring effective and experienced real estate counsel is critical for is real estate investors and owners of investment properties seeking to protect their gains from the IRS. At Gateville Law Firm we have the proper knowledge and experience assisting investors in Yorkville, Oswego, and other areas in Kendall County, Illinois with 1031 Exchanges. Contact us today at 630-780-1034.

Sources:

https://illinois.fntic.com/

https://www.law.cornell.edu/uscode/text/26/1031

https://www.irs.gov/pub/irs-news/fs-08-18.pdf

https://www.zillow.com/il/home-values/


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