Use of a 1031 Exchange will allow you defer the tax ramifications on the sale of investment property, giving you more money, and allowing you to further your investment portfolio.
A significant amount of wealth is returning to real estate holdings and investments, especially for those who weathered the crash or even took advantage of the deep discounts at the bottom in 2011. If your are thinking of selling an income producing property you need to be sure you have a plan to address the capital gains taxes you're sure to realize. By asking the right questions and understanding potential options available, you can save yourself a great deal of money, and even increase that investment portfolio. If you don't ask any questions you may be in for a large and unpleasant surprise.
Every sale or transfer of real property triggers a taxable event, unless there is an exception that applies (i.e. principal residence). As the seller of real estate that has been used for investment, you are required to pay 15-20% capital gains tax on the increase/equity (gain) from the sale of your real estate.
A brief example will illustrate how this works:
Let's say you purchased a rental property in 2011 for $150,000. You have rented the property with a consistent cash flow of $800/mo after all expenses. You are now thinking it may be a good time to cash out your investment. You checked your value at PressPlayRealty.com and find it is now worth $280,000. The equity in the property of $130,000 ($280,000 - $150,000) is now subject to the capital gains tax of $19,500-$26,000 (ouch!). To say nothing of the possibility of a Medicare surcharge tax of 3.9% that was placed on these transaction by the Obama Administration.
Fortunately there is a way to defer the need to pay the taxes at the time of the sale, but you must follow the exception precisely or else you will be responsible for paying that chunk of your gain to Uncle Same. The answer is the 1031 Exchange, called such because it is found in Section 1031 of the IRS Tax Code.
Section 1031 of the Internal Revenue Code
There are strict rules and guidelines that must be followed to ensure a 1031 exchange is successful. If any rule or timeline is not followed, you will be responsible for paying Uncle Sam as the rules provide no leeway. Here are the 5 rules you need to be keenly aware of when doing a 1031 Exchange (click here for a more comprehensive list).
- The process must be overseen by a Qualified Intermediary (“QI”). Unfortunately you cannot simply sell the property, hold the funds, and then purchase a similar property within a certain period of time. That scenario would create a taxable event, and, if completed based on your advice, you may find yourself in a law suit. A QI is an independent and professional facilitator who receives the funds. He handles the funds from the original sale and holds the funds until they are needed to purchase the new exchange property. The QI receives the proceeds (i.e. gain) from the sale of your real property and holds it until it is time to delivers the money from that sale to the escrow officer or closing company for the purchase of your new property.
- The old property must be exchanged for “like kind” property. That means, both properties, the property being sold and the property being purchased, must be used for trade or investment and they must be similar in nature (most residential real estate will qualify as like kind). A primary residence cannot be qualified as "like kind."
- You must use all of the proceeds in the purchase of the new "like kind" property. You may not divide the proceeds from your sale and use part for the purchase of the new "like kind" property and cash out the rest. It is all or nothing here.
- The new "like kind" property must be of equal or higher value than the one sold. Now you may divide the money into multiple like kind investments provided that the purchase price of each is equal to or greater than the property sold.
- The exchange must follow certain time limitations for selecting and then purchasing the new property. You have just 45 days from the date you sell your property to identify a potential like kind replacement property. The identification must be in writing, signed by you, and delivered to the QI. Notice to anyone other than the QI is not sufficient. Your like kind replacement property must then be purchased within 180 days after the sale of the original property.*
*This list is not exhaustive. There are many additional issues that may arise depending on your situation.
Not a “Tax-Free Exchange”
There are many benefits to a 1031 exchange, however, take note that the taxes are deferred not avoided. Some believe a 1031 exchange allows you to avoid being taxed until you are making less money similar to retirement disbursements, and thus, pay a reduced tax when the exchanged property sells in the future. That is not true. A 1031 exchange simply places a bookmark on the taxes owed and hose same taxes will be due after the sale of the like kind replacement property in addition to any new gains.