Section 1031 property
exchange
A 1031 property exchange is an
effective way to defer paying taxes that would otherwise have been due
on the first sale, for example - an investor bought a commercial
property, a strip mall, for $200,000. After 6 years he sells the
property for $250,000. This results in a gain of $50,000 and the
investor would have to pay capital gains tax on this amount. However if
he invests the $250,000 in another commercial real estate (like kind -
does not have to be a strip mall), then he does not have to pay any
taxes now i.e he defers his taxes till a later date.
A 1031 Exchange is similar to a traditional IRA or 401K
retirement plan. When someone sells assets in tax-deferred retirement
plans, the capital gains that would otherwise be taxable are deferred
until they begin to cash out of the retirement plan. The same principal
holds true for tax-deferred exchanges or real estate investments. As
long as the money continues to be re-invested in other real estate, the
capital gains taxes can be deferred. Unlike the aforementioned
retirement accounts, rental income on real estate investments will
continue to be taxed as net income is realized.
Like-Kind Property
Properties are of like-kind, if they are of the same nature or
character, even if they differ in grade or quality. Personal properties
of a like class are like-kind properties. However, livestock of
different sexes are not like-kind properties. Also, personal property
used predominantly in the United States and personal property used
predominantly outside the United States are not like-kind properties.
Real properties generally are of like-kind, regardless of whether the
properties are improved or unimproved. However, real property in the
United States and real property outside the United States are not
like-kind properties.
Once an investor
has decided to pursue a 1031 Exchange,
the process is fairly straightforward
and will be carefully facilitated by a Qualified intermediary. It is
suggested that you contact a QI as soon as the exchange decision has
been made. Here is a typical timeline involving an exchange, presented
in the traditional order of occurrence.
-
Investor
decides to sell investment property and do an exchange. Investor
contacts a QI.
-
Investment
property is put on the market.
-
Offer to
purchase investment property is accepted.
-
Escrow for
the sale is opened and preliminary title report produced.
-
The QI
sends required exchange documents to escrow closer for signing at
property closing.
-
Escrow
closes.
-
Within the
first 45 days after the close of escrow on the sale of the
relinquished property, investor identifies replacement property as
required by law.
-
Within 180
after the close of escrow on the sale of the relinquished property,
investor closes on replacement property that was identified by them.
The exchange is completed.
Frequently the most difficult component
of a 1031 Exchange is identifying replacement property within the
first 45 days following the sale of the relinquished property. The IRS
is very strict in not allowing extensions. The only way to extend your
45 days is on the front end, and that is done by carefully thinking
about your replacement property alternatives before you close on the
sale of your relinquished property.
|