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AN
OVERVIEW OF SEVERAL REQUIREMENTS FOR TAX DEFERRAL
WHAT
IS IRC SECTION 1031?
Section
1031 of the Internal Revenue Code allows an owner of investment property
to exchange property and defer
paying federal and state capital gain taxes (20%+ applicable state
taxes) if they purchase a “like-kind” property following the rules
and regulations of the Internal Revenue Code. This allows investors to
use all of their proceeds from their sale to leverage into more
valuable real estate, increase cash flow, diversify into other
properties, reduce management or consolidate into one property.
What
is “Like-Kind” Property?
There
is some confusion regarding what type of property qualifies for a §1031
tax deferred exchange. The
Internal Revenue Code Section 1031 states that “no
gain or loss shall be recognized on the exchange of property held for
productive use in a trade or business or for investment if such property
is exchanged solely for property of like kind which is to be held either
for productive use in a trade or business or for investment.” “Like-Kind”
property can include, but is not limited to, any of the following,
provided it is held for investment:
.
Single
Family Rental
.
Duplex
.
Apartment
.
Commercial
Property
.
Raw
Land
For
example, a single family rental can be exchanged for raw land, or
apartments or a commercial building. In addition, properties can be
exchanged anywhere within the United States.
Does
an Exchange need to be simultaneous?
No,
contrary to what most owners envision, a §1031 tax deferred exchange is
rarely a two-party swap. Most exchanges are delayed exchanges, whereby
the Exchanger has 180 days between the sale of the relinquished property
and the closing of their replacement property. They must identify the
potential replacement property(s) within 45 days from closing on their
relinquished property.
When
is a §1031 Exchange Applicable?
It
is applicable whenever a property owner intends to SELL any property
that is not their primary residence (and falls under the definition of
“like-kind”) and plans to BUY another “like-kind” property
within 180 calendar days following the closing of their relinquished
property.
Paramount to any exchange is a competent and experienced
Intermediary. Asset
Preservation is the entity which structures, consults, guides and
documents the exchange transaction from beginning to end.
AN
INTRODUCTION TO §1031 EXCHANGES
Exchanges
are a Powerful Tax Strategy
What
does investing in real estate have in common with the game of Monopoly?
Winning at both requires acquiring the most valuable real estate by
trading less desirable properties for more attractive ones. For real
estate investors, it’s easier to finish a winner by understanding the
benefits of Internal Revenue Code Section 1031 tax deferred exchanges.
By utilizing this powerful tax strategy, property owners no longer need
to leave the outcome up to “Chance.”
Tax
deferred exchanges have been a part of the tax code since 1921 and are
one of the last significant tax advantages remaining for real estate
investors. One of the key advantages of a §1031 exchange is the ability
to dispose of a property without incurring a capital gain tax liability,
thereby allowing the earning power of the deferred taxes to work for the
benefit of the investor (Exchanger) instead of the government. In
essence, it can be considered an interest-free loan from the IRS.
Basic
Tax Deferred Exchange Requirements
Although
many investors mistakenly believe an exchange is simply a
"swap" of properties, most exchanges completed in the 1990s
are variations of what is called a "delayed" exchange. In a
delayed exchange under Section 1031, the property currently owned is
called the “relinquished” property and must be exchanged for
like-kind “replacement” property. The IRS allows up to 180 days
between the sale of the relinquished property and the purchase of the
replacement property. There are a number of requirements which need to
be met to qualify for tax deferral under the tax code:
Requirement
#1:
Both the “relinquished” and "replacement" properties must
be held for investment or used in a business. The IRS uses the term
"like-kind" to describe the type of properties that qualify.
Any property held for investment can be exchanged for any other
“like-kind” property held for investment. This definition covers a
vast variety of developed and undeveloped real estate. Properties which
are clearly not like-kind are an investor’s primary residence or
property “held for sale.” The relinquished and replacement
properties need not have identical functions (I.e both be residential
rentals or commercial strip centers). For example:
o
Stewart owns two residential duplexes in Fort Worth. He can sell
them, buy three residential duplexes in Dallas, and not pay tax on the
gain from his Fort Worth properties; or
o
Stewart owns five acres of undeveloped farmland in Denton County.
He can sell it, buy a 12-unit garden apartment building in Houston, and
not pay tax on the gain from his Denton County property; or
o
Stewart owns three rental homes in California. He can sell them,
buy a retail store in Plano, and not pay tax on the gain from his
California properties.
Requirement
#2: The IRS requires an investor to identify the replacement
property(s) within 45 days from closing on the sale of a relinquished
property. The 45 Day Identification Period begins on the closing date,
and the replacement property(s) must be properly identified in a letter
signed by the Exchanger and received by the Qualified Intermediary.
Exchangers
have a number of ways to properly identify properties. They may identify
up to three target properties without regard to their total fair market
value (Three Property Rule). Alternatively,
they can identify an unlimited number of replacement properties, if the
total fair market value of all properties is not more than twice the
value of the property sold (200% Rule). As a final option, an Exchanger
can break both of these rules if they acquire 95% of the aggregate fair
market value of all identified replacement properties.
Requirement
#3:
Close on the replacement property by the earliest of either: 180
calendar days after closing on the sale of the relinquished property or
the due date for filing the tax return for the year in which the
relinquished property was sold (unless an automatic filing-extension has
been obtained). Example: If an Exchanger closes on the relinquished
property on December 27, the 180 day period will end after April 15 (Tax
Day). In this case, they would have to close on the replacement property
(or request an extension of time to file their taxes) by April 15.
Exchangers may choose to close both transactions within a shorter period
of time, thereby avoiding the potential hardship of the 45/180 day time
limits.
Requirement
#4:
The most common exchange format, the delayed exchange, requires
investors to work with an IRS-approved middleman called a
"Qualified Intermediary." The Qualified Intermediary actually
documents the exchange by preparing the necessary paperwork (Exchange
Agreements), holding proceeds on behalf of the Exchanger, and
structuring the sale of the relinquished property and purchase of the
replacement property.
Note:
To defer all capital gains taxes, an Exchanger must buy a property or
properties of equal or greater value (net of closing costs), reinvesting
all net proceeds from the sale of the relinquished property. Any funds
not reinvested, or any reduction in debt liabilities not made up for
with additional cash from the Exchanger, is considered “boot” and is
taxable. Example: Stewart sells his duplex, which he held for
investment, for $160,000. A hundred days later he closes on a different
duplex, which he will hold for investment, for $110,000.
Stewart banks the $50,000 in excess funds for his child's
education. Stewart must pay
capital gain taxes on $50,000. (In this example, Stewart chose to take
some money out of his exchange and pay the tax.)
When
Are Capital Gain Taxes Paid?
Maybe
never. Many investors mistakenly believe they will “have to pay the
taxes sometime” so they might as well just sell. Quite often, this is
a bad decision. The tax on an exchange is deferred into the future and
is only recognized when an investor actually sells the property for cash
instead of performing an exchange. Investors can continue to exchange
properties as often and for as long as they wish, thus moving up to
better investments and putting off the taxes for many years. The extra
purchasing power generated by deferring the taxes will produce increased
income and a larger investment holdings.
Unlike
those playing Monopoly, real estate investors don't have to depend upon
a "roll of the dice" to pass GO and collect more money.
Property owners should utilize tax deferred exchanges to acquire the
desirable "Boardwalk" and "Park Place" properties
and win the investment game!
WHAT
LANGUAGE SHOULD BE ADDED TO THE CONTRACT IN AN EXCHANGE?
Although
many Exchangers include language in their Purchase and Sale Agreement
establishing their intent to perform on exchange, it is not required by
the Internal Revenue Code.
Contracts
SHOULD be Assignable
It
is important, however, that the Purchase and Sale Agreements for both
properties be assignable. In
order to structure a typical exchange transaction, Asset
Preservation must be assigned in as the Seller of the relinquished
property and also as the Buyer of the replacement property.
An
Exchanger should review the contract to confirm they are not prohibited
from assigning their position as either a “Seller” or “Buyer” to
a Qualified Intermediary. When a typical exchange is initiated by Asset
Preservation, we are shown as the Seller on the Settlement Statement
instead of the Exchanger being reflected as the Seller.
The
verbiage below is satisfactory in establishing the Exchanger’s intent
to perform a tax deferred exchange and releases the other parties from
costs or liabilities as a result the exchange:
Sale
of Relinquished Property
“Buyer
is aware that Seller intends to perform an IRC Section 1031 tax deferred
exchange. Seller requests Buyer’s cooperation in such an exchange and
agrees to hold Buyer harmless from any and all claims, costs,
liabilities, or delays in time resulting from such an exchange. Buyer
agrees to an assignment of this contract by the Seller.”
Purchase
of Replacement Property
“Seller
is aware that Buyer intends to perform an IRC Section 1031 tax deferred
exchange. Buyer requests Seller’s cooperation in such an exchange and
agrees to hold Seller harmless from any and all claims, costs,
liabilities, or delays in time resulting from such an exchange. Seller
agrees to an assignment of this contract by the Buyer.”
Many
Exchangers and real estate agents add exchange language to the contract
for two reasons:
1.
It establishes their intent to perform a 1031 tax deferred
exchange;
2.
To notify the other party in advance of the need to assign the
contract to an Intermediary.
“LAST
MINUTE” EXCHANGES ARE POSSIBLE!
Even
if no language was included, many real estate investors contact our
office just minutes before closing on their transaction and
successfully convert a sale into an exchange. In most situations, a
successful exchange can be accomplished as long as Asset Preservation is
contacted prior to closing.
This
information is not intended to replace qualified legal and/or tax
advisors.
Every
taxpayer should review their specific transaction with their own legal
and/or tax counsel.
©
2000 Asset Preservation,
Inc.
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