What you should know about 1031 Exchanges!
What is a 1031 tax deferred exchange?
A 1031 exchange, in its simplest form, is a person or business entity selling real estate and purchasing other real estate. As long as the proper procedures are followed, the IRS will recognize the transaction, not as a sale and purchase, but as an exchange of a relinquished property for a replacement property.
This recognition as an exchange allows the seller to defer the payment of taxes that would otherwise be due upon the sale. Those taxes include capital gains tax, depreciation recapture tax, net investment income tax and state taxes.
When it makes sense to do an exchange?
There are many factors that must be considered to determine if an exchange will work for any taxpayer, however, the main factors are
1) Will there be capital gains tax due upon selling property
2) Do I want to continue to own real estate?
If the answer is yes to both of these questions, then a 1031 exchange is an excellent tax avoidance tool that should be considered.
What are the steps to complete an exchange?
The process of completing an exchange does include some time periods that must be adhered to in order for an exchange to be valid.
- You have 45 days to identify your replacement property. Identification simply means that you must designate, in writing, the property that you plan to acquire to complete your exchange.
- The second is 180 days to close on the new replacement property. This 180 days can be shortened if the due date of your tax return falls within the 180 days, unless an extension is filed.
There are some variations to this process depending on each exchangers situation, particularly if the exchange is a reverse exchange.
How do you begin an exchange?
Please contact a qualified intermediary near you (a simple good search helps) once you put your property on the market. They will then be able to advise on the beginning steps of an exchange. *Remember it is important that a taxpayer not take receipt of sale proceeds from their property sale. If the taxpayer touches the proceeds, an exchange is no longer possible.
Exhanges will start with:
The status of your purchase agreement?
Has a closing date been set?
Who is the closer on the sale?
Once the intermediary have this information, they will prepare the exchange documents and contact the closer to arrange for the exchange documents to be signed at closing.
What is the role of the intermediary for a 1031?
The term Qualified Intermediary is a creation of the United States Treasury Code (Section 1031 of course). Since the tax laws restrict exchangers from taking receipt of the proceeds funds from the sale of their relinquished property during the exchange, the qualified intermediary is hired to hold those proceeds, as well as, facilitate the exchange.
The intermediary must be an independent third party from the taxpayer. The intermediary cannot be an agent of the taxpayer defined as the taxpayer’s attorney, real estate agent, accountant or employee. Someone related to the taxpayer such as their spouse, parent, sibling or a related business also can’t be an intermediary. Additionally, someone related to the agent of the taxpayer as defined above also cannot be an intermediary. For instance, a title company partially or wholly owned by an attorney or real estate broker where that attorney or broker has provided services to the taxpayer is not qualified to act as that taxpayer’s intermediary.
What property can be part of a 1031 exchange?
Section 1031 of the Internal Revenue Code states that property must be exchanged for property of like kind. This language often produces some confusion. Exchangers tend to think they need to exchange for a property of similar use, but all real estate in the US is considered like kind to other real estate so long as it is held for productive use in a trade or business or for investment purposes.
For example, a duplex can be exchanged for a four-plex, rental property can be exchanged for retail property, office property can be exchanged for a warehouse, land can be exchanged for improved property etc. A vacation home used strictly for personal use does not qualify.
How to achieve maximum tax deferral?
To achieve maximum tax deferral upon completing a 1031 exchange, the exchanger must avoid receipt of proceeds from the relinquished property sale and purchase a replacement property that is equal or greater in value than the relinquished property sold.
Any proceeds received or decrease in replacement property value will likely get taxed as capital gain. A Taxpayer can still complete an exchange with some pro-rata tax deferral, even if these rules are violated, depending on the relinquished property’s basis. Of course, a Taxpayer should always work with their tax professional to determine if an exchange is right for them. Here is an excellent article on calculating gain and tax deferred with an exchange.
Can I sell or buy more than one property?
Yes, there is no limit to how many relinquished or replacement properties can be part of an exchange. If there are multiple relinquished properties, there are some factors to consider as to whether or not the sales will be considered one of multiple exchanges. The proper identification rules must also be followed if multiple replacement properties are being considered.
How do I file my taxes when I complete an exchange?
Contact your accountant!
What if I can’t find a suitable replacement property?
This is a big one! If you fail to purchase a property then the relinquished property will be taxed as an outright sale as if no exchange was ever anticipated. The most optimal strategy is to have a replacement property in mind before beginning an exchange, but that is not always possible.
If a replacement property is not identified within the 45 day period then exchange funds will be returned to the Taxpayer. Please be aware that there are limitations on when funds can be returned should an Exchangor desire to cancel an on-going exchange. The earliest date is 46 days after the sale of the relinquished property.
One of the nice benefits to beginning an exchange is that the Exchanger does have the 45 day identification period to decide if an exchange will work. Many Taxpayers see the 45 day period as an “option” period where they can shop for a suitable replacement property. If they don’t find one, then they are able to cancel the exchange by not identifying a replacement property. All exchange funds will then be returned on day 46.