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
 
Heads up before you give out advice on 1031 Tax Deferred Exchanges.  The loophole of converting highly appreciated property into your primary residence and selling at a later date to avoid taxation is quickly becoming a relic of the past under new law that went into effect as of January 1, 2009.
 
Not to worry, the conventional rules regarding exchanging investment properties from one to another have not changed.  You can still convert your investment property into your primary residence.  The new twist is when you sell under this scenario the tax benefits have been marginalized.  Most individuals are familiar with 1031 Exchanges which allow you to continually reinvest the proceeds of sale and defer taxes provided your replacement property is for investment purposes and is of equal or greater value.
 
Section 121 of the IRS pertains to primary residences and allows taxpayers to avoid tax on the first $250,000.00 of gain if single and $500,000.00 if they are married.  To obtain this benefit the taxpayer must have utilized the property as their primary residences for two of the preceding five years.  However, the days of successfully integrating both sections of the code for maximum tax benefit are limited. 
 
Previously, many taxpayers sold investment properties for a profit and avoided taxation by reinvesting the proceeds into another property. Shortly thereafter they moved into the property and made it their primary residence for two years before cashing out. Critics claimed that taking advantage of both sections of the code turned many people into serial home buyers.
 
To address this concern, Congress passed legislation in 2003 which required that before 1031 Exchange Property can be eligible for the 250k/500k exclusion, the property must be held for a holding period of 5 years.  While this holding requirement remains the same the way taxes are now computed are less advantageous to the taxpayer.
 
Effective January 1, 2009, the primary residence exclusion will not apply to gain from sale of residence that is allocable to previous periods of nonqualified use.  Nonqualified use is use of the property for investment purposes. 
 
As a result, the new law affects properties that are acquired in 1031exchanges and subsequently converted into a primary residence.  The period of use before the conversion is considered nonqualified use.  The $250,000.00 or $500,000.00 exclusion amount must be prorated, which substantially reduces the exclusion.
 
For purposes of illustration, if a taxpayer exchanged into a residence and rented it for four years and later moved into the property as a primary residence for two years and subsequently sold the residence and realized $300,000.00 of gain, please note what happens.  Under prior law, a single taxpayer would be eligible for the full $250,000.00 exclusion and would pay tax on $50,000.00.  Under the new law, the exclusion would have to be prorated as follows:
 
·       Four-sixths (4 out of 6 years) of the gain, or $200,000.00 would be ineligible for the $250,000.00 exclusion. 
 
·       Two-sixths (2 out of 6 years) of the gain or $100,000.00, would be eligible for the exclusion.
 
·       As a result the tax benefit will be marginalized and the amount due will be $150,000.00 as opposed to $50,000.00
 
The formula is complex and subject to several exclusions, for instance, periods of nonqualified uses prior January 1, 2009, are ignored, however, ownership prior to January 1, 2009, is included for purposes of applying the two year and five year tests of Section 121.  In addition, periods of nonqualified use occurring after use as a primary residence is apparently ignored.


*Tax laws are always subject to change and interpretation.  This article is meant solely as a general explanation of the 1031 Exchange.  It is recommended that you consider the advice of professionals like attorneys, accountants, Qualified 1031 Exchange Intermediaries  and investment and estate advisors in this matter.


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