Today, a friend and I had a conversation about the capital gains on his real estate investment. He has owned the property for three years now. We discussed his options if and when he sells his property. So, I brought up a “1031 Exchange.” To my surprise, he was unaware of the 1031 Exchange and its helpfulness.
This is an important topic for those who own investment properties. Section 1031 of the IRS Code is one of the most underutilized sections of the tax code. When an investor sells an investment property and subsequently buys a new investment property, the investor can defer the capital gains taxes on the sale of the original investment property. The gain is “rolled over” into the new property.
Step by step overview:
To begin, an investor would meet with a qualified intermediary to discuss a potential 1031 Exchange. The investor sells the investment property #1. After the close on property #1, the funds go to an escrow account, controlled by the qualified intermediary, to be held until property #2 is purchased. The qualified intermediary then transfers the funds for the purchase of Property #2.
Through a 1031 Exchange, an Investor saves the capital gains tax and can invest that money into another investment property. This is a government incentive for investors to continuously invest in real estate.
6 Points to Understanding the 1031 Exchange Requirements:
1. Like-Kind Property
The first requirement for a 1031 exchange is that the old property to be sold and the new property to be bought are like-kind. “Like-kind” relates to the use of properties. As a result, the old property as well as the new property, must be held for investment or utilized in a trade or business. Vacant land will always qualify for 1031 treatment whether it is leased or not. Furthermore, commercial property may be used to purchase a rental home or a lot may be sold to buy a condo.
Additional factors to consider:
- Primary residences can never be utilized in an exchange.
- Properties to an exchange must be within the United States border. Properties located outside the United States may not be involved in the exchange.
2. 45 Day Identification Period
The Internal Revenue Code requires that the new property be identified within 45 days of the closing of the sale of the old property. The 45 calendar days commence the day after closing. No extensions are allowed under any circumstances. If you have not entered into a contract by midnight of the 45th day, a list of properties must be furnished and must be specific. It must show the property address, the legal description or other means of specific identification.
Up to three potential new properties can be identified without regard to cost. If you wish to identify more than three potential replacements, the IRS limits the total value of all of the properties that you are identifying to be less than double the value of the property that you sold. This is known as the 200% rule. Accordingly, more than three properties may be identified as replacements. However, if the taxpayer exceeds the 200% limit the whole exchange may be disallowed.
It is the responsibility of the qualified intermediary to accept the list on behalf of the IRS and document the date it was received. However, no formal filing is required to be made with the IRS.
3. 180 Days To Purchase
Section 1031 requires that the purchase and closing of one or more of the new properties occur by the 180th day of the closing of the old property. The property being purchased must be one or more of the properties listed on the 45 day identification list. These time frames run concurrently, therefore when the 45 days are up the taxpayer only has 135 days remaining to close. Again there are no extensions due to title defects or otherwise. Closed means title is required to pass before the 180th day.
4. Use of a Qualified Intermediary
Sellers cannot touch the money in between the sale of their old property and the purchase of their new property. By law, the taxpayer must use an independent third party commonly known as an exchange partner and/or intermediary to handle the change. The party who serves in this role cannot be someone with whom the taxpayer has had a family relationship or alternatively a business relationship during the preceding two years.
The function of the exchange partner/intermediary is to prepare the documents required by the IRS at the time of the sale of the old property and at the time of the purchase of the new property. The intermediary must hold the proceeds of the sale in a separate account until the purchase of the new property is completed. The taxpayer is entitled to the interest of these funds and must treat the interest as ordinary income during the period of escrow.
5. Title Must be Mirror Image
Section 1031 requires that the taxpayer listed on the old property be the same taxpayer listed on the new property. If you and your wife are married and sell the old property than you and your wife must also be on the title to the new property. If a trust or corporation is in title to the old property that same trust or corporation must be on title to the new property.
6. Reinvest Equal or Greater Amount
In order to defer 100% of the tax on the gain of the sale of old property, the new property must be of equal or greater value. There are actually two requirements within this rule. First, the new property has to be of greater or equal value of the one which is sold. Secondly, all of the cash profits must be reinvested.
In reality, you may deduct closing expenses and commissions from the sale of the property being sold. If the property is being sold for $500,000.00 and the actual net amount after closing expenses is $465,000.00, then $465,000.00 is required to be spent for the replacement property.
A party who elects to do an exchange and take cash out may do so. However, any cash received will be taxed at the corresponding rate of ordinary income if held for less than one year or the capital gains tax if held for more than one year.
Want to learn more about a 1031 exchange? Contact us here.
Another option to avoid paying capital gains tax on the sell of your property is called seller financing. Find out more about your seller financing option here