1031 Tax Exchange
OVERVIEW OF 1031 EXCHANGE?
- A 1031 tax deferred property exchange is an exchange in which capital gains tax deferral is available to real estate owners who sell their investment, rental, business or vacation real estate, and reinvest the net proceeds in other real estate. Real Estate held for these purposes are called like-kind or 1031 properties. Property owners may sell like-kind properties and defer taxes on the sale's profits by meeting the requirements of Internal Revenue Code (IRC) 1031 exchange. The purpose of the 1031 Exchange is to allow sellers of like-kind property to buy replacement property of like kind within a specific time period and to defer taxes. Sellers have a maximum of 180 calendar days from the closing of the initial sale to complete the exchange. Within the first 45 days of this period a seller must designate candidate properties and properly identify them to the IRS. A seller may target up to three properties regardless of value or a group of properties with a combined value that does not exceed 200 percent of the value of the initial property sale. The funds in a trust account can be used as earnest money for designated property once all IRS requirements for a 1031 transaction are met. If no new properties are identified in the first 45 days or no designated transaction is completed during the full 180 day period, the trust will be liquidated and the sale proceeds will be taxed at the prevailing capital gains rate. For more information on 1031 exchanges, please click here to go to The Internal Revenue Service web site. Also, visit the site below for more in depth 1031 Exchange Information.First Exchange
WHAT IS A 1031 EXCHANGE?
- Internal Revenue Code Section 1031 provides that no gain or loss will be recognized on the exchange of any type of business use or investment property for any other business use or investment property. 1031 Exchanges are not really exchanges in the context of two-party barter. Instead, they are typical sales and purchases that involve the same exact ingredients as any other sale or purchase, without the capital gains. The only real difference is the investor is increasing his selling and buying power by electing to avoid the drain of taxes under Section 1031 regulations. No other aspects of the transaction are affected.
WHO SHOULD CONSIDER A 1031 EXCHANGE?
- Anyone who is thinking about selling a business use or investment property should consider affecting a 1031 Exchange. An Exchange offers the astute investor an opportunity to reinvest the federal capital gains that would normally be handed over to the IRS and put that money to work for himself. You work too hard to simply pay the tax without carefully considering this reinvestment option. Essentially, 1031 Exchanges should be thought of as an interest free loan from the IRS; one in which the principal may be increased through subsequent exchanges and may never require repayment, if you plan properly.
MISCONCEPTIONS ABOUT EXCHANGING
1. Many still believe that you must “Swap” properties. Although this was required in the original code, this is rarely done in present times. 1031 Exchanges now enable one to sell their property to someone totally unrelated to the person from whom they are purchasing their replacement
2. Many believe only investors of large commercial properties can utilize the benefits of Section 1031. The great thing about 1031 Exchanges is that it applies to all investment properties, large and small. It will work the same way for a corporation selling a large shopping center as it would for an individual selling a single-family home used as a rental property in a vacation area.
3. Many believe you must acquire a property of “similar use or service.” While 1031 exchanges are also known as “like-kind” exchanges, like-kind simply applies to real property held for business use or investment. Therefore, an investor may sell raw land and acquire a five-unit apartment building or sell a warehouse and acquire raw land. He can sell one property and acquire three or sell four and acquire one. Virtually any type of real property used for business use or investment will qualify.
4. Many believe 1031 exchanges are very complicated and not worth doing. The fact is that when working with a qualified intermediary who specializes in Section 1031 tax deferred exchanges, the exchange process is very simple. The intermediary will keep you aware of your time deadlines and ensure you do everything in strict compliance with IRS regulations.
ADVANTAGES OF EXCHANGING
1. The Exchanger will have more buying power because the federal income taxes are deferred. This will enable him to leverage himself up greater than he could have he paid the tax liability. The additional equity to reinvest will make him a more solid buyer and help him get easier financing.
2. Investors can do exchange after exchange to create a pyramiding effect. This tax liability is forgiven upon the death of the investor as the heirs get a stepped up basis on the inherited property.
3. The Exchanger will have greater selling power because he does not have to inflate the sales price to try to cover some of the capital gains that would normally be due upon the sale of an investment property. It will enable him to be more flexible with the selling price.
4. The Exchanger can acquire a replacement property with greater income potential. He can sell raw land and acquire income-producing property. Perhaps, he wants to acquire a building with additional units or in an easier to rent location.
5. The Exchanger has the opportunity to consolidate several hard to manage properties in one easy to manage property or diversify several small properties into one large property. It provides an excellent opportunity to relocate or expand a current business or investment.
6. An exchange can also help an investor acquire a less management intense property.
BESIDES TAX REDUCTION, 1031 EXCHANGES CAN ACCOMPLISH MANY GOALS:
- Estate preservation Increased buying power because of greater cash flow. Increased selling power because the federal capital gain tax liability is deferred. Exchange for property with an increased income (more rental units, higher rental income per unit, lower operating expenses, easier to rent location, etc.) The need or desire to relocate a business or investment property. Exchange for property that requires less management. Exchange for property that is easier to finance. Consolidate smaller properties into a larger property Diversify a large property into several smaller properties. The need or desire to expand a business into a larger space. All of the above culminates into one significant power-The ability to create pyramiding wealth accumulation in real estate ownership.
- The basis of your replacement property will be lowered by the amount of gain deferred on the sale of your relinquished property. However, when weighing this against the deferred gain, the astute investor can clearly see he is still significantly ahead.
THE PROPERTIES IN THE EXCHANGE
- RELINQUISHED PROPERTY: The relinquished property is the business use or investment property the Exchanger owns and wants to sell via the 1031 Exchange.
- The replacement property is the business use or investment property the Exchanger wants to acquire to complete the 1031 Exchange. There can be more than one of each of the relinquished and replacement properties. For example, an Exchanger can sell three small properties and purchase one large property or sell one large property and acquire four smaller ones. An Exchanger does not have to purchase the same type of property. For example, he can sell a storage facility and acquire an apartment building or sell a raw piece of land and acquire a shopping center.
THE PARTIES INVOLVED IN THE EXCHANGE
EXCHANGER: The Exchanger is the taxpayer who is electing to defer the capital gains by affecting a 1031 Exchange.
SELLER: The seller is the person who owns the property the Exchanger wishes to acquire as a replacement property.
BUYER: The buyer is the person who wants to purchase the property the Exchanger is selling.
INTERMEDIARY: The use of a qualified Intermediary is required by the regulations of Section 1031. The role of the Intermediary is to act as a middleman in both the sale and purchase transactions.