Few sections of the Tax Code have as much impact on the real estate investor as Internal Revenue Code Section 1031 (I.R.C. §1031). This allows an investor who is selling business or investment real estate to complete an exchange by purchasing other like-kind property and deferring up to 100% of the taxes otherwise due at the time of sale.
Normally, when you sell property held for investment or business purposes for a greater value than that which you originally paid for it, any gain you realize from the sale will be subject to capital-gains tax. However, a Section 1031 Exchange—also called a tax-deferred exchange— allows you to sell a domestic property (excluding personal use property such as a primary residence or second home) and acquire a domestic replacement property through an exchange method, allowing you to defer having to pay capital-gains taxes resulting from the initial sale. This allows you to, in effect, reinvest the sale proceeds without having to pay additional taxes and can therefore be a powerful money-saving tool if used correctly.
Since exchanging can range anywhere from a single swap of two properties to a complex, multi-leg, multi-party transaction involving construction and/or reverse exchanges it is imperative that you speak with real estate and escrow agents that are experienced in dealing with property exchanges.
Besides tax deferral other benefits include income stability, retirement planning, wealth preservation and efficient estate planning. Common reasons to do a 1031 Exchange:
- Trade up to larger investment properties to build wealth.
- Relocate real estate investments (keep them geographically nearby if you have moved).
- Change the type or character of real estate investments.
- Diversify or consolidate real estate investments to or from multiple properties.
- Trade nonproductive property for real estate investments that produce income.
- Leveraging in an upmarket (putting down as little of your own money and maximizing the amount of financing). Every dollar saved in taxes allows you to purchase that much more real estate.
The true power of exchanging is the ability to meet investment objectives without losing equity to taxation.
Under the like-kind rule covering property used in business or held for investment, all the following examples would qualify for a tax deferral under a 1031 Exchange:
√ Exchange a rental house or condo to an apartment building.
√ Residential income property to commercial property.
√ Vacant land to a rental house or apartment building.
√ Industrial warehouse to vacant land.
As you can see, just about any real estate you intend to trade to any other real estate qualifies so long as the properties have been, and will be, used in business or held for investment.
Completing a 1031 Exchange (4 step process):
Engage a Qualified Intermediary (http://www.starker.com/) to facilitate your property sale. Waiting until after the closing will be too late! A “Qualified Intermediary” is a person other than the Exchangor (taxpayer) or a person related to the Exchangor who, for a fee, acts to facilitate the exchange by (i) acquiring the relinquished property from the Exchangor and (ii) acquiring the replacement property and subsequently transferring it to the Exchangor. The Intermediary serves as the conduit to acquire, sell, buy and dispose of property in order to effect a tax-deferred exchange for the Exchangor.
Sell your existing property. Cash proceeds are escrowed by your Qualified Intermediary. There is a strict requirement that the exchanger (taxpayer) not get actual or constructive receipt of the funds. You must arrange the exchange before the sale closes on the relinquished property so you don’t run afoul of this no-receipt-of-funds rule.
Identify one or more replacement properties within 45 days after the sale of your original property.
Purchase (title acquired) your replacement property to complete your 1031 exchange within 180 days after the sale of your original property.
The IRS takes the 45-day identification and 180-day acquisition time requirements very seriously. If you are a day late and your exchange is audited, the exchange will be disallowed; as far as the IRS is concerned these time requirements are set in stone.
PLEASE NOTE: If you own businesses, highly appreciated stock, commercial or residential investment real estate assets, and are reluctant to sell those assets because of the capital gains taxes associated with the sale, I have two additional alternatives to a 1031 Exchange or a taxable sale to help you reduce capital gains tax liability.