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Questions and Answers
Question: What is a
1031 Exchange?
Answer:
Under
section 1031 of the Internal Revenue Code, a real property owner can
sell his property and then reinvest the proceeds in ownership of
like-kind property and defer the capital gains taxes. To qualify as
a like-kind exchange, property exchanges must be done in accordance
with the rules set forth in the tax code and in the treasury
regulations. The 1031 exchange can offer
significant tax advantages
to
real estate buyers.
Often overlooked, a
1031 exchange is considered one
of the best-kept secrets in the Internal Revenue Code.
Why should you consider a 1031
exchange?
· Defer paying
capital gains taxes.
· Leverage.
· A properly
structured exchange can provide real estate investors with the
opportunity to defer all of their capital gains taxes. By
exchanging, the investor essentially receives an interest-free,
no-term loan from the government.
· Relief from
property management. The lessee takes the responsibility to sublet
and maintain the property allowing real estate buyers to avoid most
of the day-to-day management headaches.
· Upgrade or
consolidate property.
· Diversify. Own
multiple properties rather than just one.
· Change property
types among residential, commercial, retail, etc.
What are the 1031
exchange rules?
The real property you sell and the real property you
buy must both be held for productive use in a trade or business or
for investment purposes and must be like-kind. The proceeds from the
sale must go through the hands of a
qualified intermediary (QI)
or the proceeds will become taxable. All the cash proceeds from the
original sale must be reinvested in the replacement property - any
cash proceeds that you retain will be taxable. The
replacement property
must be subject to an equal level or greater level of debt than the
relinquished property or the buyer will either have to pay taxes on
the amount of the decrease or have to put in additional cash funds
to offset the lower level of debt in the replacement property.
Replacement property identification
3-property rule:
You may identify any three properties as possible replacements for
your relinquished property. More than 95% of exchanges use the
3-property rule.
200% rule:
You may identify any number of properties as possible replacements
for your relinquished property as long as the aggregate value of
those properties does not exceed 200% of the value of your
relinquished property.
95% exemption:
You may identify any number of properties as possible replacements
for your relinquished property as long as you end up purchasing at
least 95% of the aggregate value of all properties identified.
1031 Timeline
Identification Period:
Within 45 days of selling the relinquished property you must
identify suitable replacement properties. This 45 day rule is very
strict and is not extended should the 45th day fall on a Saturday,
Sunday, or legal holiday.
Exchange Period:
The replacement property must be received by the taxpayer within the
“exchange period,” which ends within the earlier of . . . 180 days
after the date on which the taxpayer transfers the property
relinquished, or . . . the due date for the taxpayer tax return for
the taxable year in which the transfer of the relinquished property
occurs. This 180-day rule is very strict and is not extended if the
180th day should happen to fall on a Saturday, Sunday or legal
holiday.
The role of the Qualified Intermediary
(QI)
The QI is a 1031
exchange Intermediary or entity that can legally hold funds to
facilitate a 1031 exchange. To be qualified, the 1031 exchange
intermediary must not be relative or agent of the exchanging party.
The use of a Qualified 1031 Exchange Intermediary is essential to
completing a successful 1031 exchange process. The QI performs
several important functions including creating the exchange of
properties, holding the 1031 exchange proceeds and preparing the
legal documents.
Why tenants in common (TIC)?
A TIC is a form
of real estate asset ownership in which two or more persons have an
undivided, fractional interest in the asset, where ownership shares
are not required to be equal, and where ownership interests can be
inherited. Each co-owner receives an individual deed at closing for
his or her undivided percentage interest in the entire property.
Through TIC ownership, the average person is able to enjoy ownership
in an institutional-type property with a minimum investment.
Buying investment property as tenants
in common enables you to invest in larger properties and diversify
across different types of investment property, geographic markets,
and real estate companies, thus potentially increasing both the
value and safety of your investments.
Who should consider a 1031 exchange?
If you have real
property that will net you a gain upon sale (generally property that
has been substantially depreciated for tax purposes and/or has
appreciated in fair market value), then you are exactly the person
who should consider a 1031 exchange. There are 5 tax classes of
property:
1) Property used in taxpayer’s
trade or business.
2) Property held primarily for sale to customers.
3) Property which is used as your principal residence.
4) Property held for investment.
5) Property used as a vacation home.
Section 1031 applies to
the first and fourth categories, and potentially the fifth category.
Business use is defined as, “To hold property for productive use in
trade or business.” Property retired from previous productive use in
business can be qualifying property. Investment purpose defined as
real estate, even if unproductive, held by a non-dealer for future
use or increment in value is held for investment and not primarily
for sale. Investment is the passive holding of property, for more
than a temporary period, with the expectation that it will
appreciate. Property held for sale in the immediate future is not
held for investment.
Feel free to contact me
for more information on a 1031 Exchange.
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