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Understanding the 1031 Deferred Tax Exchange ° A 1031 exchange is a rare opportunity: a true win-win situation for both the seller and buyer of a commercial property. Basically, a tax deferred exchange is an intrest-free loan from the government compliments of Section 1031 of the Internal Revenue Code. Under Section 1031, a taxpayer may, in some instances, completly defer payment of taxes by trading rather than selling his or her real estate. ° 1031 exchanges may be the last and best tax shelter available for real estate investors. They are available to owners of investment property or property used in a trade or business. ° Tax deferred exchanges are relatively easy to accomplish through the use of a qualified intermediary. Minimal cooperation is needed from other parties involved in the exchange. However, the tax rules and consequences can be serious, so investors interested in an exchange should consult their legal or tax advisor before proceeding. The main purpose for tax deferred exchanges is to postpone paying capital gains taxes. When you "sell" or actually trade an investment property and reinvest the proceeds, you get more efficient use of your equity. It's "more bang for your buck" that many tax advisors recommend for the majority of investors who meet the requirements of this proven tax strategy. The idea behind the 1031 tax exchange is that the equity in one investment property, when transferred to another investment property, is still the same equity and there is a continuation of the same investment cycle, only in a different asset. For example, one can exchange a duplex for a four unit apartment, a four unit apartment for a 12 unit apartment, a lot for a duplex, raw land for an apartment, an apartment for raw land, land for an office building, land for a commercial property, or multiple properties for other investment properties as long as the timing and number restrictions are followed (see below for time and number of property limitations). The term "like kind exchange" is often used in the market place. Fortunately the type of property exchanged can be almost any type of real estate as long as it is used as an investment property. See the following definitions for more information. In addition, two way exchanges are very rare. It is unusual to find
a situation in which two investors "fall in love" with each
others property. Most common are three way exchanges in which you "sell"
your property to a buyer, put the funds into a safe harbor, and reinvest
your proceeds into your target property or properties. Tax deferred exchanges are somewhat detailed and an expert tax advisor should always be consulted. The IRS definition of a tax deferred exchange is as follows: No gain shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind, which is to be held either for productive use in trade or business or for investment. Only assets allowed to be exchanged are Section 1231 (such as farm and ranch) or Section 1221 (such as real property used in your trade or business or as rental property) assets. It is clear that any real property held by exchanger as Section 1231 or Section 1221 property may be exchanged for any real property that is to be held by the exchanger as Section 1231 or Section 1221 property. Exceptions This subsection shall not apply to any exchange of: - Stock in trade or other property held primarily for sale Stock in trade or other property held primarily for sale. This exception specifically excludes the inventory property classification of assets. Developers may, of course, use exchanging as a disposition plan, but they will not qualify for the tax deferral treatment under Section 1031. Other securities or evidences of indebtedness or interest. This exception relates to the carry-back financing that sellers acquire in installment sale. While one trust deed may be traded for another trust deed, the transaction will not be treated as a tax deferred exchange. Interests in a partnership. This exception relates to partnerships that own real estate. The partnership may exchange the qualifying property it owns for other qualifying property and receive the tax deferral promised in Section 1031. The partners, however, cannot exchange their partnership interests on a tax deferred basis. The partnership interests owned by the investors are personal property. IRS Section 761 deals with the requirements which must be met to complete the exchange of partnership interests. Time Frame The 180-day time limit imposed is strictly for the purpose of making sure that taxpayers are able to file their tax returns in a timely manner. The 180-day period during which the taxpayer has to acquire a replacement property is further broken down into time segments. The first section tells us that the taxpayer has 45 days to identify the property he/she is going to acquire in the exchange. Multiple properties may be identified prior to the 45Th day, but on the 45Th day, the final identification must be made. Identification Period and Exchange Period. The identification period begins on the date of taxpayer relinquished property and ends at midnight on the 45Th day thereafter. The exchange period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the earlier of the 180Th day thereafter or the due date (including extensions) for the taxpayer’s return of the tax imposed… for the taxable year in which the transfer of the relinquished property occurs. The above time limits cannot be extended. If the 180Th day falls on a weekend or holiday, the dates are not extended. The taxpayer must be certain to have the escrow closed on the acquired property within the timeframe. The Three-Property Rule The regulations issued by IRS place further restrictions on the identification process. The taxpayer has two choices. One choice is to identify three properties, regardless of their value in relation to the value of the property being relinquished Treatment of Deferred Exchanges. Alternative and Multiple Properties. The taxpayer may identify more than one replacement property. Regardless of the number of relinquished properties transferred by the taxpayer as part of the same deferred exchange, the maximum number of properties that the taxpayer may identify is Three properties without regard to the fair market values of the properties (the three-property rule), or… The 200-Percent Rule The second choice the taxpayer has is to identify more than three properties, but the market value of the total properties identified must be less than 200% of the market value of the property being relinquished Any number of properties as long as their aggregated fair market value as of the end of the identification period does not exceed 200 percent of the aggregate fair market value of all relinquished properties as of the date the relinquished properties were transferred by the taxpayer (the 200-percent rule)… Identification of Properties Regulations have been issued that direct an investor on the proper method of identifying the property(ies) within 45-day period. The identification must be made in writing and be delivered to the proper person. Manner of Identifying Replacement Property. Replacement property is identified only if it is designated as replacement property in a written document signed by the taxpayer and hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period to either the person obligated to transfer the replacement property to the taxpayer… The property to be identified must be identified unambiguously through its legal description, address, or common name. Safe Harbor Rule During the exchange the taxpayer cannot receive property that is considered not like kind. Receipt of non-like-kind property is considered cash and is not qualified for tax deferred exchange. Safe harbors (1) in general… safe harbors, the use of which will result in determination that the taxpayer is not in actual or constructive receipt of money or other property for the purpose of Section 1031… To qualify for the 1031 Deferred Tax Exchange investor may use services of Realtor’s Title Corporation to facilitate the exchange. It is essential for the taxpayer to create a paper trail establishing the intent to complete an exchange. Realtor’s Title Corporation will assist you in completing successful 1031 Tax exchange. Always consult your tax attorney or tax advisor for additional specifics for your situation. If you are interested in initiating a 1031 Tax Deferred Exchange, please contact us at tip_info@TexasIncomeProperty.com
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