The 1031 Exchange...What is it?
With a 1031 exchange, you
can defer capital-gains taxes on the sale of an investment property by "swapping" with another property of equal or greater value. (If your
replacement property costs are not equal you may face a tax bill.)
You can
exchange almost any type of investment property except a home you live in now.The 1031 exchange is tax-deferred, not tax-free. When the replacement property is
ultimately sold (not as part of another exchange), the original
deferred gain, plus any additional gain realized since the purchase of
the replacement property, is subject to tax.
What are the benefits of an exchange vs. a sale?
An owner profits can be
protected from capital gains taxes. The 1031 exchange can help defer
taxes and help preserve the appreciation. That is why tax-deferred
exchanges or trades continue to be an attractive alternative to an outright sale,
where gains are paid when the transaction is made. Many of
retirees wanting to protect gains or create a stable income can use the
1031 exchange. Remember, its complicated and you should use a professional to guide this
process.
How does it work?
A property owner identifies
a like-kind property that qualifies for the exchange. A like-kind
property is one of more or less comparable value as the first property
being exchanged. Now like properties can have different uses. For
example an apartment building could be exchanged for a warehouse, Like refers to properties of similar value rather than similar use.
What are the property
requirements for a valid exchange? You must exchange real estate for
real estate. The IRS uses a liberal definition in its interpretation of like-kind
properties and views almost all real estate as similar in nature. Any combination of office buildings, apartments,
factory buildings, shopping centers, stores, hotels, motels, farms or
parking lots is permitted.
You must use an
Intermediary to make a 1031 exchange. 1031 exchanges aren't
do-it-yourself projects: You cannot sell a property and then buy
another directly. Instead, you must use a middleman, who sells the
property on your behalf, buys the next one and then transfers the deed
to you. According to IRS rules neither your attorney, accountant or
broker can be your middleman. Nor can a parent or a child. The
middleman often used is known as a qualified intermediaries.
Note: Always ask for references and proper insurance. Ask to see
the policy and note the policy numbers. Be sure the Insurance has not
lapsed. The QI should have a current fidelity bond and
errors-and-omission (E&O) insurance which cover you against fraud
or negligence by the QI. 1031 Exchanges are not uncommon, but they are
tricky and you want to be sure that your swap is IRS compliant or there
will be a tax
The four general guidelines
to follow:
1. There must be an actual exchange and not a sale.
2. The
properties exchanged must be of like kind.
3. The property transferred
and the property received must be held for productive use in a trade or
business or for investment.
4. The taxpayer must meet the specified
timing requirements
The time restrictions on
completing a Section 1031 exchange:
- A taxpayer has 45 days after the
date that the relinquished property is transferred to properly identify
potential replacement properties.
- The exchange period begins on the
date the property is transferred and ends on the date that is the
earlier of 180 days after the date of the transfer or the due date of
the relinquishing party's income tax return for the taxable year.
Note: These are general
remarks please use a professional and consult with a tax attorney. Laws
are constantly changing.
What is Boot? Boot is the money or the fair market value of "other
property" received by the taxpayer in an exchange. Money includes all
cash equivalents plus mortgages or liens
assumed by the other party.
Strategy:
Retirees: A retiring investor eager to protect
gains or reduce taxable income can use the 1031 exchange.
For example: A retiring investor could shift equity from an apartment complex or
small strip mall into a passive property which would not create
income. This strategy might work for a retiree not in need of income but wanting to preserve the whole asset for heirs.
A growing number of
retirees eager create a stable income stream can use the 1031 exchange:
For Example: An owner of an income producing property such as an apartment building
or mall might seek to exchange this kind of asset with its management
problems and vacancy rates for a less risky real asset. Exchanging a variable income asset such as rental property for a small
commercial building that has a triple net, 30 year lease and a low risk
tenant such as a large corporation would give the retiree a virtual Fixed Annuity with no management problems.
Deferring the tax creates
wealth: Equity in the property remains intact, and any capital gains
liability can be deferred until the property is sold. This ability to use the tax money saved in a 1031 exchange can be applied to the investment and earn money as well. By deferring the capital gains tax on the trade, that money can be used to increase the owverall investment return.
