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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!
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