TAX-DEFERRED EXCHANGE BASICS
TAX-DEFERRED EXCHANGE BASICS
When you sell your interest in investment property, you may incur federal capital gains taxes and, in some states, state taxes as well. Your attorney, tax advisor, or real estate professional may suggest a tax-deferred exchange under Section 1031 of the Internal Revenue Code. A tax-deferred exchange allows you to dispose of investment properties and acquire “like-kind” properties while deferring federal capital gains taxes and depreciation recapture. Most states with a capital gain tax offer a similar tax advantage, too. Bottom line: a tax-deferred exchange allows you to reinvest sales proceeds that would otherwise be paid to the government in the form of taxes.
Knowing some basic rules behind Internal Revenue Code 1031 can help investors defer paying capital gain tax on property dispositions, resulting in more money to invest in new property acquisition. Generally, any real or personal property can be exchanged, provided it is held “for productive use in a trade or business” or for “investment” and is exchanged for property of “like-kind” that will also be held for one of these same purposes.
The replacement property must be considered “like-kind” to the relinquished property. Any real or personal property can be exchanged, provided it is held “for productive use in a trade or business” or “for investment” and is exchanged for property of “like-kind” that will also be held for one of these same purposes. “Like-kind” does not mean “exactly the same,” particularly with the exchange of real property. The like-kind requirement is fairly broad for real property exchanges. A single-family rental unit, for example, may be exchanged for other real property like a warehouse, retail center, office building, farm property, or even a leasehold interest in real estate of 30 years or more. All real property is considered “like-kind” to all other real property, but property inside the United States is not “like-kind” to property located outside of the United States. “Like-kind” limitations on personal property are more restrictive. Essentially, items of personal property must be classified similarly under certain government accounting classifications.
SAME TAXPAYER RULE
In order to qualify for tax-deferral treatment, the same Taxpayer selling the relinquished property must purchase the replacement property. For example, if Company B sells the relinquished property, Company B must also acquire the replacement property. An exception to this requirement is entities that are considered disregarded for tax purposes, such as single member limited liability companies and revocable trusts. For example, Sue Smith may own a commercial building in her own name. She can sell that property and acquire replacement property in her own name, or she may take title in the name of a limited liability company in which she is the sole member, or she may create a revocable trust and take title in the name of the trust. In each case Sue Smith is still considered the same Taxpayer thus allowing her to complete an exchange.
HOLDING FOR INVESTMENT PURPOSES
Both the relinquished and replacement properties must be held for investment purposes or for use in the Taxpayer’s business. Property that is held for the purpose of appreciation or for rental income should satisfy the investment requirement. Typical exchange transactions involve an office or commercial building, a rental home or an apartment building. Personal residences, vacation homes frequently used by the owner, and property held for sale (i.e., new homes constructed by a homebuilder) would not qualify. Mixed use properties such as home offices or duplexes in which the investor lives in one unit and rents the other unit can qualify for a tax-deferred exchange for the portion of the property used for business or investment purposes.
The tax code does not clearly specify a minimum time frame for which investor must continue to hold the investment property to qualify for tax-deferral treatment. However, when the IRS examines exchange transactions, the Taxpayer must be able to show that the Taxpayer intended to hold the property for investment purposes at the time it was acquired. If a Taxpayer only holds his replacement property for a few months prior to selling it, the IRS may question whether the investor actually intended to hold the property for investment purposes.
TIMING AND IDENTIFICATION
The Taxpayer has 45 days from the closing of the relinquished property to identify replacement property. Proper identification of replacement property is a requirement for a valid exchange, and the investor can only acquire property which has been properly identified during the 45-day identification period. Replacement property that is acquired (i.e., closes) within the 45-day time period is considered properly identified. For property not purchased within the 45-day time frame, the identification must unambiguously describe the property (with an address or legal description), and must be made in writing, signed by the Taxpayer and sent before midnight of the 45th day. If multiple relinquished properties are grouped together in one exchange, the 45-day time period starts to run as of the closing of the first property.
If a Taxpayer wants to identify more than one replacement property, there are several options. The two most common methods to identify multiple properties are:
- The “Three Property” rule: the investor may identify up to three properties without regard to their fair market value; or
- The “200%” rule: the Taxpayer may identify any number of properties so long as the total fair market value of all of the listed properties does not exceed 200% of the value of the relinquished property.
Once escrow closes on the relinquished property, the Taxpayer has the lesser of 180 days from the date of closing, or the date on which the Taxpayer’s tax return for the year the relinquished property was sold is due, to close the purchase transaction and complete the exchange. For exchanges closing in the final quarter of the year, the Taxpayer will need to get an extension to file his tax return to get the full 180 days.
*Source: All 1031 content provided by First American Exchange Company
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