What is a 1031 “Like Kind Exchange”?

Owners of real estate for investment purposes (that is property other than their principal residence) must consider the tax consequences of their gain before entering into a binding agreement to sell. While there are generous exemptions on capital gains taxes when a principal residence is sold, gains from investment property have immediate income tax consequences. A growing number of sellers of investment property are taking advantage of an Internal Revenue Service provision that allows the proceeds from a sale to be isolated in a special account and then used to purchase new investment property while avoiding gains tax.

The IRS provision, codified in the tax code in Section 1031, sets out specific requirements that a real estate seller must follow to qualify for the tax exemption. First, as might be inferred from the description of the transaction, the property being sold and the property to be purchased must be of a “like kind”, meaning they must be similar, but not identical, in character. For instance, if the property being sold is a three family residence, the “replacement property” must also be residential, but not necessarily a three family. A seller of an office building could not take advantage of the provision to purchase residential property.

Second, the proceeds must be kept completely segregated from the sellers other assets and accounts. This is accomplished through the engagement of a “third party intermediary,” or “exchange agent.” While the seller keeps title to the property until the date of closing, and transfers title to the buyer by deed, the exchange agent takes possession of the proceeds from the sale until directed by the seller to distribute the proceeds toward the next purchase.

A real estate seller who elects to take advantage of the 1031 exemption is not required to know what property will be purchased with the proceeds. The rule allows for the “replacement property” to be identified and purchased within six months of the initial sale. The exchange agent then participates in the purchase by advancing the segregated funds toward the purchase. Any excess proceeds, not needed for the purchase, are subject to taxation at the seller’s applicable capital gain rate.

Contact a Massachusetts Real Estate Lawyer

For more information on selling investment property in Massachusetts, or if you are looking for a real estate lawyer in Massachusetts, please contact Rob D. Stewart. If you prefer, you can also telephone our offices in Boston seven days a week at toll free 866-414-0400.

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