A powerful wealth building tool still available to taxpayers. It has been a major part of the success strategy of countless financial wizards and real estate gurus. In most of our minds the question lies, "what do the big boys do?? If all of the tax loop holes are for the rich, well, what can the average taxpayer do??" OK, here is the answer we've all been looking for! If you arrange for the sale of your business or investment properties as an "Exchange", such as "trade" properties so to speak, and then reinvest all of the money from your sale into buying more business or investment properties, you will pay NO INCOME TAXES! Yes, its true!
Also, your income taxes are actually deferred (postponed) until the day you decide to outright sell your property and pocket the sales proceeds. You can even avoid "ever" having to pay the income taxes at all by continuing to exchange properties throughout your entire lifetime! Then, with proper estate planning, you can pass it all to your heirs completely TAX-FREE!!
Taking its name from Section 1031 of the Internal Revenue Code, a tax-deferred exchange allows a taxpayer to sell income, investment or business property and replace it with a like-kind property. Capital gains on the sale of this property are deferred or postponed as long as the IRS rules are meticulously followed. This is a wise tax and investment strategy as well as an estate planning tool. In theory, an investor could continue deferring capital gains on investment property until death, potentially avoiding them all together.
In the early days of "like-kind exchanges," the term was taken quite literally and often posed difficulties. For instance, if you owned a three-story brick apartment building that you wanted to sell through a 1031 exchange, you would have to find another three-story brick apartment building whose owner wanted to swap. Then the two of you would meet and the exchange would take place.
In the past, there were no time constraints on the exchange. The IRS demanded stricter controls on the process, which resulted in Congress passing in 1984 Section 1031(a). This legislation limited deferred exchanges, further defined "like-kind" property and established a time table for completing the exchange.
Although a part of the nation's tax code since 1921, 1031 exchanges did not enjoy wide popularity until about 30 years ago, thanks to a Ninth Circuit Court case known as the Starker ruling that focused on section 1031 of the tax code. Investors today routinely use the 1031 exchange process to leverage the sale of investment real estate or personal property. As of 2005, more than $200 billion of real assets changed hands through this mechanism, and millions of investors have benefited by preserving their equity. How so?
With 1031 exchanges, the investor has the potential for financial growth greater than an investor receives by simply buying and selling. He or she has the potential of saving between 15% and 30% or more in taxes because of the ability to defer tax obligations to a later date.
There are important rules for conducting 1031 exchanges. In addition to the new purchase being of equal or greater value than the sale, 1031 participants must identify the new purchase within 45 days of sale and complete the transaction within 180 days of sale. The investor also must place the proceeds in the hands of a neutral, qualified third party, which will complete the exchange of real estate within the 180-day period. All of which leads to a key question: How does one identify a third party to carry out the transaction?
There are only two possible disadvantages worth noting. One of them being that you will have a slightly lower depreciation schedule when you acquire your new properties. This is because the IRS will look at your new tax basis as being the same as your previous one; less your deferred gain.
The other disadvantage is that losses on your income tax return cannot be deducted if you exchange property rather than sell it. So, if you want to take a loss, just call it a sale, not an exchange
In two recent cases, Southwest Exchange and the 1031 Tax Group committed some serious errors in judgment and management. Rather than exchange clients' funds in separate accounts, they commingled or merged their operational funds with client funds for private company purposes.
Commingling might have helped the exchange companies, but it put investors at risk, especially when some needed their now unavailable funds to complete the transfer process. For any industry specialist, this practice raised a huge red flag.
Acquired by owners with little industry experience, the two companies didn't follow 1031 exchange practices. Their sloppy operations illustrate the right and wrong ways to conduct 1031 exchanges. The industry trade association that sets 1031 exchange standards suspended the two companies from membership for unethical practices. Fortunately, the industry has become so professionalized that the recent incidents stand out as rare exceptions.
Real estate property held for business use or investment qualifies for a 1031 Exchange. A personal residence does not qualify and, generally, a fix-and-flip property also doesn't qualify because it fits in the category of property being held for sale. Vacation or second homes, which are not held as rentals do not qualify for 1031 treatment; however, there is a usage test under Paragraph 280 of the tax code that may apply to those properties. A tax expert should be consulted in this case.
Land, which is under development, and property purchased for resale do not qualify for tax-deferred treatment. Stocks, bonds, notes, inventory property, and a beneficial interest in a partnership are not considered "like-kind" property for exchange purposes.
To qualify as a 1031 exchange today, the transaction must take the form of an "exchange" rather than just a sale of one property with the subsequent purchase of another. First, the property being sold and the new replacement property must both be held for investment purposes or for productive use in a trade or a business. They must be "like-kind" properties.
The following types of real estate swaps fit the requirement for a qualified exchange of "like-kind" property:
Today, you could exchange that brick apartment building for raw land, a warehouse, or a small office building. However, there are strict time constraints which must be met or the 1031 Exchange will not be allowed and tax consequences will be imposed.
Prior to 1984, virtually all exchanges were done simultaneously with the closing and transfer of the sold property, (Relinquished Property), and the purchase of the new real estate, (Replacement Property). In addition to the problems encountered when trying to finding a suitable property, there were difficulties with the simultaneous transfer of titles as well as funds.
The delayed 1031 Exchange avoids those pre-1984 problems but stricter deadlines are now imposed. A taxpayer who wants to complete an exchange, lists and markets property in the usual manner. When a buyer steps forward and the purchase contract is executed, the seller enters into an exchange agreement with a Qualified Intermediary who, in turn, become the substitute seller. The exchange agreement usually calls for an assignment of the seller’s contract to the Intermediary. The closing takes place and, because the seller cannot touch the money, the Intermediary receives the proceeds due the seller.
At that point, the first timing restriction, the 45-Day Rule for Identification, begins. The taxpayer must either close on or identify in writing a potential Replacement Property within 45 days from the closing and transfer of the original property. The time period is not negotiable, includes weekends and holidays, and the IRS will not make exceptions. If you exceed the time limit, your entire exchange can be disqualified and taxes are sure to follow.
Three properties without regard to their fair market value. Any number of properties as long as their aggregate fair market value at the end of the identification period does not exceed 200% of the aggregate fair market value of the relinquished property as of the transfer date. If the three-property rule and the 200% rule is exceeded, the exchange will not fail if the taxpayer purchases 95% of the aggregate fair market value of all identified properties. Realistically, most investors follow the three-property rule so they can complete due diligence and select the one that works best for them that will close. Generally, the goal is to trade up to avoid the transfer of "boot" and keep the exchange tax-free.
"Boot" is the money or fair market value of any additional property received by the taxpayer through the exchange. Money includes all cash equivalents, debts, liabilities to which the exchanged property is subject. This is "non-like-kind" property and the rules governing it during the exchange are complex. Suffice it to say, without expert advice, receiving "boot" can result in taxes.
Once a replacement property is selected, the taxpayer has 180 days from the date the Relinquished Property was transferred to the buyer to close on the new Replacement Property. However, if the due date on the investor's tax return, with any extensions, for the tax year in which the Relinquished Property was sold is earlier than the 180-day period, then the exchange must be completed by that earlier date. Remember, a portion of this period has already been used during the Identification Period. There are no extensions and no exceptions to this rule, so it is advisable to schedule the closing prior to the deadline.
Since the law requires that the taxpayer not touch the proceeds from the first transaction, the Qualified Intermediary acquires the Replacement Property from the seller at closing and after the transaction is completed, then transfers it to the taxpayer.
This is a basic description of how a successful 1031 Exchange works. Depending upon the taxpayer’s situation, the type of property relinquished and the characteristics of the Replacement Property, other aspects of the Exchange may be involved. Its completion may become complex and experts should always be consulted. This is no task for a "do it yourself" investor.
Using the power of the 1031 Exchange to build and preserve wealth and assets, generate cash flow from investments, restructure, diversify and consolidate real estate holdings is the right of every owner of investment property in the United States. American taxpayers should never have to pay capital gains taxes on the sale of their investment property if they intend to reinvest those proceeds in more investment property.
Real estate investors must be wise not only in choosing their purchases, but also in selecting the professionals who help them negotiate their acquisitions. That's why the recent failures of two 1031 real estate exchange companies created a stir among some investors as well as experts in the business of transferring properties.
Qualified intermediaries, or exchange accommodators as they are sometimes called, are specialists trained to facilitate the transfer of 1031 exchanges. In handling 1031 funds, qualified intermediaries establish individual accounts, making sure not to commingle their funds with client funds. The idea is to show transparency to the client at all times.
While banks or title companies include 1031 services as part of their larger operations, independent qualified intermediaries are dedicated solely to facilitating 1031 exchanges. Qualified intermediaries also provide transfer-related counseling, something that usually comes in handy when processing complicated real estate deals. Fees usually range between $500 and $1,000 per exchange, depending upon the complexity of the deal.
A respected trade association, The Federation of Exchange Accommodators (FEA), has developed standards for its 330 members that include background checks, independent FDIC-backed bank accounts for each transaction, fiduciary performance bonds, multiple signature requirements for fund transfers, and a code of ethics for the industry.
The FEA offers a comprehensive three-year training program that culminates with the Certified Exchange Specialist (CES) designation for participants who pass a rigorous examination.
Using experts such as 1031 exchange specialists is a sound step to protecting the financial investment throughout the entire transfer process. Just make sure you select someone who is experienced and is a specialist in 1031 exchanges and you'll be secure throughout the entire process.
This material is neither an offer to sell nor the solicitation to purchase any property. The information is for discussion and information purposes only. It is not intended to replace competent legal, tax or financial planning advice. The applicable tax codes apply to and relate to federal law only. Individual states may have their own additional tax codes. Please contact the appropriate tax and legal professional in your state. This information is provided from sources believed to be reliable but should be used in conjunction with professional advice that is consistent with your personal situation.