Defer Capital Gains Tax with a 1031 Exchange
A 1031 Exchange is the section number of the IRS code that details
the method of deferring the payment of the tax on capital gains from the sale of
a property which is not your primary residence and which has been rented or
available for rent. The deferred amount varies depending upon the amount of time
the property is held. If it is owned for at least a year and a day, the deferred
tax is computed on the basis of long term capital gain. In an ordinary sale of
real estate, (except for the sale of a primary residence inhabited by you for at
least two out of the last five years), capital gains are taxed on any gain
realized on the sale of a property. But in a 1031 Exchange, you must reinvest
the gain from the first sale into another property "of like kind." This term
simply refers to another property or properties that are also investment/rental
properties. Bare land also qualifies as property eligible for a 1031 Exchange.
The beauty of the 1031 exchange is that the taxpayer may dispose of property without incurring any immediate tax liability. Most importantly, it allows the taxpayer to keep the "earning power" of the deferred tax dollars working for himself in another investment. In effect, it is like an "interest free loan" to you from the IRS. By continuing to sell and buy rental properties or land this "loan" can be increased through subsequent exchanges. Additionally, this tax liability is forgiven upon the death of the taxpayer: THE ESTATE NEVER HAS TO REPAY THE TAX. The heirs inherit the property at the time of the taxpayer's death at fair market price.
The properties that are sold and purchased do not have to be the same type of properties. For example, you may own a single family home and you may exchange it for two condo units, or any combination of properties up to three individual investment properties as long as the total market value of these properties at the time of the identification period does not exceed 200% of the value of the original relinquished property. This may be done again after the next property has been owned for a year and a day.
How does it work?
1. Both the old and the new properties must qualify as investment or business use. If both properties pass this test, you can exchange nearly any properties.
2. List the "relinquished" (old) property for sale with a realtor who will disclose the intent to complete an exchange on the listing agreement.
3. The seller enters into contract with a buyer for the sale of the relinquished property and obtains the buyer's cooperation.
4. The seller notifies a "Qualified Intermediary" who prepares the exchange agreement and coordinates with the escrow holder. The exchange documents must be in place and signed by all parties prior to the close of escrow. The QI may not be a friend,employee, your banker, realtor, accountant or attorney. The QI must hold all the money that is to be transferred.
5. You have 45 days from the closing date of the first property to identify a list of properties you may want to buy. There are no exceptions to the 45 day deadline.
6. From the date of closing, you have 180 days to close on the purchase of one or more of the properties you have identified from the 45 day list. There are no exceptions.
7. Title for the new property must be taken in exactly the same "name" or entity as the old property.
8. To defer all of the capital gains tax, you must purchase a property or properties of equal or greater value than the one you sold. Also, you must reinvest all of the cash proceeds from the sale.
Certain 1031 Tax Deferred Exchanges Marginalized Under New Law
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