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AN INTRODUCTION TO THE BENEFITS OF §1031
TAX DEFERRED 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:
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 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
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!
Back to Table of
Contents 1031 Exchange Information |
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Unless otherwise stated square footage and lot dimensions appearing herein are
derived from county records and may or may not be accurate.
If square footage is material to a transaction a survey or other measurement is
recommended. This information deemed reliable but not guaranteed. Current or
previous year’s taxes may not accurately forecast future property taxes.
Property taxes can increase from one year to the next for various reasons.
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