Defer taxable gains…with a 1031 Exchange.
Section 1031 Exchange is a useful tool for real property owners who want to defer taxes when property is sold. Code Section 1031 allows property to be sold while preserving net worth.
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Thanks to Section 1031 of the Tax Code, a properly structured like-kind exchange allows an investor to sell a property in certain situations, reinvest the proceeds in a different property, and defer capital gain taxes. The four basic steps in a 1031 exchange are:
- The seller arranges for sale of property and includes exchange language in the contract.
- At closing, proceeds from the sale go to a qualified intermediary for a 1031 exchange.
- The seller identifies potential exchange properties within 45 days of closing.
- The seller completes the 1031 exchange within 180 days of closing.
Here’s how it works: Let’s say you have a $200,000 capital gain and incur a tax liability of approximately $50,000 in combined taxes (depreciation recapture, federal and state capital gains taxes) when the property is sold. Only $150,000 remains to reinvest in another property.
Assuming a 25 percent down payment and a 75 percent loan-to-value ratio, you would only be able to purchase a $600,000 different property. However, with a 1031 exchange, you’d be able to reinvest the entire $200,000 of equity in the purchase of $800,000 in real estate, assuming the same down payment and loan-to value ratios exist.
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1031 Exchange Explained
Although the logistics of selling one property and buying another are virtually identical to any standard sale and purchase scenario, an exchange is different because the entire transaction is memorialized as an exchange and not a sale. And it is this distinction between exchanging and not simply selling and buying which ultimately allows the taxpayer to qualify for deferred gain treatment. So essentially, sales are taxable and exchanges are not.
Indeed, any property owner who expects to acquire Replacement Property subsequent to the sale of their existing Property should consider a Delayed Exchange. To do otherwise would necessitate the payment of capital gain taxes in amounts that can exceed 20-30%, depending on the appropriate combined federal and state tax rates. In other words, when purchasing Replacement Property without the benefit of a Delayed Exchange, your buying power is dramatically reduced and represents only 70-80% of what it did previously.
There are two basic concepts to a Delayed Exchange. First, the purchase price of the Replacement Property must be equal to or greater than the net sales price of the Relinquished Property. Secondly, all equity received from the sale of the Relinquished Property must be used to acquire the Replacement Property.
Four Common Exchange Misconceptions
- All exchanges must involve swapping or trading with other property owners. (NO) Before delayed exchanges were codified in 1984, all simultaneous exchange transactions required the actual swapping of deeds and simultaneous closing among all parties to an exchange. Often times these exchanges were comprised of dozens of exchanging parties as well as numerous exchange properties. But today, there is no such requirement to swap your property with someone else in order to complete an exchange. The rules have been streamlined to the extent that the current process is reflective more of your qualifying intent rather than the logistics of the property closings.
- All exchanges must close simultaneously. (NO) Although there was a time when all exchanges had to be closed on a simultaneous basis, they are rarely completed in this format any longer. In fact, a significant majority of exchanges are now closed as delayed exchanges.
- Like-kind means purchasing the same type of property which was sold. (NO) The definition of like-kind has often been misinterpreted to mean the requirement of the acquisition of property to be utilized in the same form as the exchange property. In other words; apartments for apartments, hotels for hotels, farms for farms, etc. However, the true definition is again reflective more of intent than use. Accordingly, there are currently two types of property that qualify as like-kind:
- Property held for investment, and/or
- Property held for a productive use in trade or business.
- Exchanges must be limited to one exchange and one replacement property. (NO)This is another exchanging myth. There are no provisions within either the Internal Revenue Code or the Treasury Regulations that restrict the amount of properties that can be involved in an exchange. Therefore, exchanging out of several properties into one replacement property or vice versa, relinquishing (selling) one property and acquiring several, are perfectly acceptable strategies.