1031 Tax-Deferred Exchange
Q: What is a Tax-Deferred Exchange?
A 1031 exchange allows you to defer the payment of capital gains taxes associated with real estate transactions. By selling one property and buying a higher-priced property, you can also get additional depreciation deductions, which can act to increase your after-tax income.
Only a few simple rules must be followed in order to qualify a real estate transaction as a 1031 exchange. First, only property held for business or investment purposes can be used in a 1031 exchange, and both properties in the transaction must be of "like kind". Like kind property is real estate or other tangible property that is similar in nature or classification.
Q: What are the tax advantages in a 1031 exchange?
You can defer the payment of capital gains taxes associated with real estate transactions. By selling one property and buying a higher-priced property, you can also get additional depreciation deductions, which can act to increase your after-tax income. In addition, you can eliminate paying taxes on the recapture of depreciation you've taken on the property.
Q: Can I use my primary residence or second home in for a 1031 exchange?
No, only real estate property held for business or investment purposes can be used in a 1031 exchange, and both properties in the transaction must be of "like kind".
CONVERTING A PRIMARY RESIDENCE INTO A RENTAL
The IRS gave guidance in Revenue Procedure 2005-14 on how to report a conveyance of property used as the taxpayer’s primary residence and then held as investment property. A taxpayer may convert a primary residence into a rental and then sell it and benefit from both Internal Revenue Code (IRC) §121 (primary residence) and IRC §1031 (investment property). The taxpayer must comply with all rules in both sections to qualify.
All the exchange requirements under IRC §1031 must be met to defer the remaining gain and depreciation. These include:
- reinvesting all the remaining net proceeds into the replacement property;
- obtaining an equal or greater amount of new debt on the replacement property that is required; and
- having the same taxpayer who sold the relinquished property acquire the replacement property.
The IRS gives six examples in the revenue procedure at www.irs.gov by searching for Revenue Procedure 2005-14.
TIME IS IMPORTANT
The taxpayer has 180 days to complete the exchange and during the first 45 days, the taxpayer must identify the replacement property or properties.
Q: What is meant by "like-kind" property in a 1031 exchange?
A: Like kind property is real estate or other tangible property that is similar in nature, characteristics, or SIC classification in a 1031 exchange. Whether two properties are of "like kind" can also be dependent on state law.
Q: Can I sell or buy multiple properties in a 1031 exchange?
A: Yes, you can exchange multiple smaller properties for a larger one and vice versa. The key is always trade up in value in order to maximize the amount of capital gains taxes that are deferred.
Q: Are their time restrictions on a 1031 exchange transaction?
A: Yes, there is a 180-day time span in which the 1031 exchange must take place. During this period there is also a 45-day period where the exchanger must identify which replacement property will be purchased.
Q: How can I defer the maximum amount of capital gains tax in a 1031 exchange?
A: The main rule is that the replacement property being purchased must be equal or greater in value to the relinquished property being sold. The net effect must be that the entire net proceeds from the sale must be used to purchase the replacement property.
Q: Does one receive cost basis for the replacement property?
A: No, cost basis from the relinquished property is carried forward to the replacement property in a 1031 exchange. This is one drawback and is often overlooked or misunderstood.
Q: What is a Qualified Intermediary and must I use one in a 1031 exchange?
A: The Qualified Intermediary, also called an accommodator, is a third-party that facilitates the transaction and is required by the IRS to qualify a 1031 tax exchange. The IRS does not allow your accountant, attorney, or escrow company to act as the Qualified Intermediary.
Q: Can I do multiple 1031 exchanges and avoid paying taxes altogether?
A: Yes, by continuing to sell and buy like-kind properties and following 1031 rules, your estate when you die can avoid paying capital gains taxes.
NOTE: Properties International Limited nor its agents can not and does not provide advice regarding specific tax consequences. Investors considering a 1031 tax-deferred exchange should seek the counsel of their accountant and/or their attorney.