WHAT IS A TAX DEFERRED EXCHANGE?
Internal Revenue Code Section 1031 allows you the opportunity to defer capital gains taxes owed upon the sale of investment or income property by exchanging the property for other like-kind property. The IRS states specific guidelines that must be followed and a Qualified Intermediary provides for a safe harbor exchange.
SHOULD AN EXCHANGE BE CONSIDERED?
This is an individual decision based on the your overall investment goals. You may have a financial or tax advisor, but ultimately you will be the one writing the check to the Internal Revenue Service if they decide to sell and pay the capital gains tax. You should contact a Qualified Exchange Intermediary and find out if a §1031 Exchange is right for you.
WHAT IS CAPITAL GAINS TAX?
Capital gains is the difference between what a property sells for and the “adjusted basis” in the property. When investment property is purchased, the purchase price becomes the initial cost basis. If you make capital improvements to the property, the cost of those improvements will increase the basis in the property, adjusting the basis upwards. Depreciation is a benefit to owning investment property which allows for a yearly deduction of a portion of the value of the property improvements. Click here to calculate your capital gains tax.
Depreciation cannot be taken on land. Any depreciation taken is a reduction in the basis of the property.
ISN’T CAPITAL GAINS TAX ONLY 15%?
No. Gain from appreciation (the increase in your property value) is taxable currently at a maximum of 15%. However, the gain from the depreciation is taxed at 25% depreciation recapture. In addition, most states will charge state tax.
WHAT IS THE DIFFERENCE BETWEEN A SALE AND AN EXCHANGE?
A sale is an exchange of property for cash or other property which is not “like-kind” to real estate and therefore taxable. The IRS states that an exchange is a non-taxable sale because you, the taxpayer will sell investment property and replace it with investment property, which is like-kind.
WHAT DOES LIKE-KIND MEAN?
IRC §1031(a)(1) allows for the exchange of property held for productive use in a trade or business or for investment for like-kind Replacement Property. A myriad of court cases and IRS rulings have established the definition of “like-kind” real estate to be very broad. Examples of like-kind property include single-family rentals, multi-unit housing, commercial or industrial properties, ranches, and bare land. Provided a property has not been personally used, such as a principal residence or second home, it should qualify for a §1031 Exchange.
CAN THE EXCHANGOR BE AUDITED BY DOING AN EXCHANGE?
No more than if you just sold the property. The tax-deferred exchange has been a part of the Tax Code in one form or another since 1921. Just like Individual Retirement Accounts (IRA’s), if you follow the rules and guidelines, the law allows for tax deferral until the property is ultimately sold and you receive the cash.
WHAT’S THE BENEFIT IF TAXES WILL EVENTUALLY HAVE TO BE PAID?
With proper estate planning, you may never pay capital gains tax! There are many tax-planning vehicles that allow taxpayers to relinquish their low basis assets (such as real estate) without paying taxes. Gifts to loved ones, charitable contributions, and certain irrevocable trusts are just a few options available to savvy investors.
Even without a complex estate plan, if you exchange instead of sell it will benefit your heirs. Any property included in a descendant’s gross estate will be transferred to your heirs with a basis “stepped-up” to fair market value. This means that all capital gains in the property will be wiped away provided the estate’s value does not exceed the statutory exclusion limitations.
You must first select a Qualified Intermediary (“QI”) to facilitate the exchange. A QI is a professional company that specializes in processing §1031 exchanges. The QI’s services must be retained prior to the closing of the existing property. Waiting until after the closing will be too late!
The QI is hired to prepare the exchange documentation and to hold the sale proceeds during the time between the sale of the existing property (Relinquished Property) and the acquisition of the new property (Replacement Property). The law requires the proceeds from the sale of the existing property be kept from your control until a suitable Replacement Property is identified and ultimately transferred to you by the QI.
HOW SHOULD A QI BE SELECTED?
You should select a QI based on its expertise, experience, integrity, and years in the exchange business. Starker Services, Inc. (“SSI”) is the nation’s largest and oldest independently owned Qualified Intermediary. SSI facilitates thousands of exchanges each year and has been doing so for almost two decades!
HOW ARE THE EXCHANGE FUNDS PROTECTED?
With longevity comes stability. SSI offers you two decades of exchange accommodation experience. In addition, SSI maintains a $1,000,000 fidelity bond (click here to view bond) to protect you from loss. Each exchange account is segregated which adds another layer of security making SSI one of the safest QI’s in the nation. It is also Starker’s policy that two Corporate Officer signatures are required to transfer funds at any time.
AFTER A QI IS CHOSEN, THEN WHAT?
Upon closing the sale of the Relinquished Property, you must adhere to two timetables which both begin on the date the existing property is transferred. First, you must identify, in writing, possible replacement properties within 45 days of the closing. The QI will provide you with a form on which you may list up to three potential replacement properties of any value. Once you have completed the ID form, you must fax or mail it to the QI by 11:59PM on the 45th day.
Second, you must acquire at least one of the identified properties prior to the expiration of the 180-day replacement period. Again, this period begins on day the Relinquished Property closes. You may buy more than one of the identified properties provided if they all close within the 180-day period.
The inability to acquire any of the identified properties will cause an exchange to fail. There is no mechanism for alternative property selection once the 45-day identification period has elapsed.
CAN CASH BE TAKEN OUT WHILE STILL DOING AN EXCHANGE?
Yes! However, any cash received will be subject to capital gains tax. You may take cash out at the closing of the sale property or upon completion of the exchange. Since you will be taxed on any proceeds being removed from the exchange, it will also be necessary to determine what your capital gain would be had you simply sold your property. If you take cash out equal to or more than your capital gain, then you will be paying all the tax owed. An exchange at this point would be needless.
Clients considering the sale of investment or income property should first consult your financial or tax advisor to determine if a tax-deferred exchange will benefit your long-term investment goals and retirement plans. Ultimately, you must decide whether to take advantage of an IRC Section 1031 exchange or write a check to the IRS!
This material is provided for informational purposes only and is not to be construed as tax advice. The reader is strongly advised to speak with a tax consultant before attempting to employ any of the concepts stated herein.