IRS – Section 1031 Tax Favored Exchanges Explained
What is a 1031 Exchange?
A 1031 Exchange is simply a method by which a property owner trades one property for another without having to pay federal and state income taxes. Ordinarily, the owner is taxed on gain realized by the sale of the old property, but in an exchange the tax is referred until sometime in the future.
Are 1031 Tax Deferred Exchanges Authorized?
Tax deferred exchanges are authorized by Section 1031 of the internal Revenue Code. The requirements of 1031 and related code sections must be carefully met, but when done properly, the entire tax due on the sale can be deferred. It is important to remember the tax is not eliminated; it is only deferred, meaning you will have to address the issue sometime in the future, usually when the new property is sold. It is imperative to seek the advice of a CPA well versed in real estate taxation before considering a 1031 exchange transaction.
How can a 1031 Exchange benefit me?
The main benefit of a 1031 Exchange is the deferral of taxes. The tax that otherwise would have been paid gets reinvested as equity into the new property, a wealth building technique. Other benefits include:
• Greater leverage capability to buy more property.
• Change, consolidate or diversify your investments by asset class or geographic location.
• Improve cash flow, for example exchanging from bare land into income producing property.
• Replace fully depreciated assets into new property to restore basis and future depreciation expense.
• Elimination of day to day management obligations.
• Incorporate estate planning strategies with family members by balancing estate values among them.
• UnderanewlRSrulingandproper1031 planning, you can even exchange into a property that can one day be your principal residence, and eliminate most of the tax!
The 6 IRS Rules for a 1031 Exchange…
Straight or Forward Exchanges involve selling the old property first and then buying the new property. When conducting a forward exchange, you must follow these 6 simple rules:1. Real Property Use – Both your old and new properties must qualify as held for investment or income producing. If both properties pass this test, you can exchange nearly any type of real estate.
2. 45 Day Identification Period – You have 45 calendar days from the closing of your sale to list the properties you may want to buy. You can list up to 3 with no restrictions, over 3 there are IRS rules that need to be followed to the letter.
3. 180 Day Exchange Closing Period – From the sale closing date, you have 180 calendar days to close on the purchase of one or more properties from the 45 day list. There are no exceptions to either the 45 Day Identification Period or the 180 Day Closing Period deadlines.
4. Qualified Intermediary (Ql) – The IRS mandates that you use a Ql to prepare the legal documents for your exchange. The Ql must be an independent third party, and cannot be your friend, employee, broker, or even your CPA or Attorney. The Ql also holds your money so you don’t have access to it.
5. Proper Title Holding – You must purchase and take title to your new property exactly as you held title to your old property.
6. Reinvestment Requirement – To defer all of your capital gains tax, you must buy a property equal or higher in value than the one you sold.
Typical exchanges are forward in nature and dictate selling the old property first before buying the new one. Unlike a forward exchange, you may be in a situation where you want or need to buy the new property before you’ve sold the old one. The problem is the IRS wiil not allow you to hold title to both the old and new properties at the same time.
The Reverse Exchange allows you to conduct the exchange in the reverse order, yet still enjoy the tax benefits. In a reverse exchange, your Ql arranges to buy the new property for you and holds it for a period of time.
There are several reasons to consider the reverse exchange:
• Market conditions are making it difficult to find a buyer for your old property, and the new one you want is priced to sell.
• You need to buy the new property now, but desire more time to sell the old one to get the “right price”.
• You want to make improvements to the new property, or construct a new building on raw land.
• You face the possibility of losing your deposit or favorable financing rates.
In these circumstances, the reverse exchange provides you with the flexibility, leverage and buying power while preserving your equity through a tax deferral.
The IRS Position on Reverse Exchanges
In 2000, the IRS issued Revenue Procedure 2000-37, known as a “Safe Harbor Reverse”, a ruling that gives taxpayers guidance on how to safely conduct the reverse exchange. These guidelines are precise, require specific documentation and must be completed within 180 days.
If your situation is such that the reverse may fall outside the 180 days, such as in construction projects, then Traditional Reverse Exchanges (non-safe harbor) have helped clients in these situations for many years.
While Safe Harbor and Traditional reverse exchanges are similar, there are unique considerations and procedures for each. Working with our CPAs and Attorneys to structure your reverse exchange will give you the confidence and assurance to meet your needs and stand up to IRS scrutiny.