1031 EXCHANGES TO DEFER CAPITAL GAIN TAXES ON PROPERTY SALES
Nobody likes to pay taxes upon the sale of real estate. Specially not on investment or commercial properties. However, by knowing the basic rules of how Internal Revenue Code 1031 works, property owners can defer the payment of capital gains taxes resulting in additional monies to invest in further property acquisition.
How it works: In order to qualify under Section 1031, the property must first qualify as an “investment or commercial” property. This means, it is not solely used as the property owner’s homestead. Second, the sale of the property has to be treated as an exchange, meaning one property is being sold and a new one being purchased. In order to qualify, the money earned at the time of the sale can not ever touch the seller’s hands. By using what is referred to as a “qualified intermediary” or a 1031 exchange company, the money is held by the company until you are ready to buy the new or “replacement property”. The replacement property must also be similar in nature to the property being sold. That is, it must also be held for investment as well. But the rules are flexible. For example, an office building, can be exchanged for vacant land. Or an apartment building can be exchanged for a duplex or single family home, as long as it is going to be used for investment purposes.
Lastly, the seller must remain the same throughout the sale and purchase. For example, if “XYZ Corp.” sellers Property A, then “XYZ Corp” must also buy Property B. But again, the rules are flexible and creativity can go a long way. If Holly Homeowner owns a commercial building in her own name, she can acquire the new building under the name of an LLC, as long as she is the sole member of the LLC. Or if she creates a trust and takes title under the name of the trust. Holly Homeowner is still considered the same taxpayer under the 1031 Exchange allowing her to defer any capital gains and complete the 1031 exchange.
Some “investment” properties like vacation homes, used even seasonally by a homeowner, may not qualify under the rules. However, mixed use properties, such as home offices or duplexes where the property owner lives in one unit but rents out the other, may qualify for the portion that is rented out.
DEFERRING THE TAX
In order to avoid triggering any requirement to pay taxes, the replacement property that the investor is purchasing must be equal in value or greater in value then the property that is being sold. If it is not, then the transaction may result in partial tax having to be paid.
TIME LIMITS
Section 1031 Exchanges also have strict time limits. The seller has 45 days from the date the property is sold and closed to identify the replacement property. As long as closing takes place within the 45 days, then the exchange qualifies for tax deferral. If the closing does not take places within 45 days, the investor may still qualify as long as certain written requirements are met. It is also helpful that the IRS allows for a seller who has not yet closed on the replacement property, to identify three properties and then must close within 180 days from the date of closing.
EXCELLENT INVESTMENT OPPORTUNITY
Tax-deferred 1031 Exchanges can be an excellent tool for investors to avoid paying taxes at the time of selling real estate property. If used correctly, it can result in more money to invest in property acquisition.
The single most important tool however is working with a real estate attorney who is both knowledgeable in 1031 Exchanges and has the 1031 team in place to make the whole process run smoothly, without any guesswork. As both a Real Estate Attorney and Accountant, I have been assisting investors for over 23 years with their 1031 Exchanges. We can work with you to prepare the contract for sale, identify the replacement property, prepare all the required IRS forms, and meet all the deadlines to defer your capital gains. Working with the right team can make all the difference between paying taxes or having more money to invest.