1031 Tax Deferred Property Exchanges
Pacific Beach Real Estate, Mission Beach Real Estate, San Diego County Real Estate
One of the questions I am continually asked is about the purchase of investment real estate/rental property and the deferral of capital gains tax on the sale. Because I am asked about this almost on a daily basis, I thought the subject of IRC 1031 Tax Deferred Exchanges would make for an informative article.
Essentially, the 1031 exchange is a tremendous tax saving vehicle because it permits individuals to attain real wealth through tax deferred real estate investing. It allows investors to defer capital gains taxes on the sale of business or investment property if they use a facilitator to receive the sale proceeds and reinvest them in "like-kind" property. In the tax code it states:
The theory behind section 1031 is that if a taxpayer does not actually receive any money or non-like-kind property at the real estate closing, then there is no money or value for the Internal Revenue Service (IRS) to tax. Constructive receipt could occur when money or property is credited to the taxpayer´s account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it at any time, if notice of intention to draw is given.
Prior to 1979 it was thought that the only way for a taxpayer to avoid actual or constructive receipt was to have the sale ("relinquished") property and the purchase ("replacement") property close simultaneously. Since then the Internal Revenue Code and the Treasury Regulations were amended to require a taxpayer to merely identify the replacement property within 45 days and to close escrow within 180 days after the transfer date of the relinquished property.
Most transactions commonly use an intermediary. A qualified intermediary is a neutral entity that enters into a written agreement with the taxpayer to acquire a "like-kind" replacement property, chosen by the taxpayer. During the closing process, the qualified intermediary is "assigned in" as the seller of the relinquished property and the buyer of the replacement property, while the taxpayer becomes the "exchanger."
When escrow of the relinquished property closes, the title company or escrow officer wires the money to the qualified intermediary, who holds the funds until the exchanger identifies, on a form provided by the qualified intermediary, the replacement property or properties he or she would like to purchase. When the exchanger is ready to close on the replacement property, the qualified intermediary transfers the exchanger´s equity to the title company or officer handling the replacement property closing. By employing this middleman concept, the taxpayer is able to defer all federal and state capital gains taxes that would normally be due on the sale of property.
Three Main Requirements
There are three main requirements that a taxpayer must meet before reaping the rewards of a tax-deferred exchange.
- The relinquished property and the replacement property must both be held for "productive use in a trade or business or for investment." Thus, section 1031 does not apply to property held for personal use, such as a primary residence, for which there are other tax rules.
- An exchanger must identify the replacement property in writing within 45 days of transferring the relinquished property. During the course of the 45 days, an exchanger may revoke the first identification form and list new properties on a replacement identification form many times. However, after the 45h day any properties acquired must appear on the most current identification form. If the exchanger plans to sell more than one property, the 45/180 day timelines will begin to run from the date the first relinquished property closes and title transfers.
- After identifying replacement properties, the exchanger must close on one of them by the earlier of either (1) 180 calendar days after the transfer of the relinquished property or (2) the exchanger´s tax return due date, including extensions, for the tax year in which the relinquished property was transferred.
A legitimate 1031 exchange does not guarantee that the exchanger will have absolutely no tax liability on the entire transaction. For an exchange to be fully tax-deferred, an exchanger must (1) buy an investment property or properties of equal or greater value (net of allowed closing costs), and (2) reinvest all net proceeds from the sale of the relinquished property in the replacement property. Any money not reinvested, or any reduction in debt liability is considered taxable income.
For More than the Basics...
The above information represents only the basics of 1031 Tax Deferred Exchange investing. Please, only work with real estate professionals, broker and tax specialists, who are experienced in 1031 investing. If the exacting rules and regulations that must be followed to achieve a full tax deferral are not met, the IRS and state tax board can disqualify the exchange and require the taxpayer to ante up the tax that would have been due plus interest and possible penalties.