The federal and state capital gain and recaptured depreciation tax triggered on the sale of property held for productive use in a business or investment can be effectively minimized in a 1031 tax deferred exchange. The 1031 exchange offers investors the IRS sanctioned ability to defer the capital gains tax on real and personal properties; as a result that allows the investor to re-invest 100 percent of the net proceeds from the sale of the property and replace the retired debt into a new one. Completing a 1031 exchange is a very precise process and there are many aspects to be noted.
Andy Gustafson
Misinformed Call for Demise of the 1031 Exchange
“Should tax reform include the removal of Treasury Regulation Section 1031 tax deferred exchanges?” is a question that, for the misinformed, the answer appears to be “Yes.” The discussion underway is how to reform the tax code affecting billions of dollars of tax subsidies for individuals and corporations. As one of two hundred tax appropriations annually quantified by the bipartisan Joint Committee on Taxation, the 1031 exchange is estimated to cost $42 to $47 billion over a five year period. The manner in which these numbers are determined has changed tripling the previous $15 billion estimate. Here are the previous estimates:
Deferred Taxes
Interested in deferred taxes? Internal Revenue Code Section 1031 allows that “no gain or loss when shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.” This means when selling real or personal property held for business or investment, the federal and state capital gains and recaptured depreciation taxes can be deferred indefinitely or until the replacement property is sold.
Minor Repairs in a 1031 Exchange
As the velocity of real estate sales picks up, questions surface regarding how best to repair the replacement properties in a 1031 exchange. There are two acceptable strategies and one not acceptable strategy. Before reading more, for those not familiar with a 1031 exchange and you are selling real property held in a business or for investment, continue to press forward. In the era of tax deferrals or for those who wish to minimize their tax bill, learn now, rather than when your accountant asks if you are familiar with a 1031 exchange, when it may be too late.
1031 Exchange
A 1031 exchange is a section of the Internal Revenue Code and a Treasury Regulation that allows the deferral of recaptured depreciation, federal, state and local capital gains taxes when property held for the proper intent is sold and replaced within 180 calendar days. Taxes can add up to 40 percent of the property sales price. The code applies to real property only. Examples of real property include any type of property from land, single family residential rentals, condominiums, commercial, oil and gas royalties to fractional interests in commercial properties.
Repairs
Repairs can be made to the replacement property using the exchange proceeds, given the property is owned by an Exchange Accommodator Titleholder (EAT). An EAT is a single member limited liability company that enters into a Qualified Exchange Accommodation Agreement and other exchange agreements to pay the approved contractor invoices. Either before the 180th calendar day or by the 180th day post the old property closing, the improved property is conveyed to the taxpayer. A warranty deed is created, signed, notarized and recorded with the County Clerk of Court for real property.
A second strategy, one that is difficult and unlikely to secure, is allowing improvements to be made before the closing. At the replacement property closing, the contractors are paid for work completed as itemized expenses on the settlement statement and not for future services. Most Sellers will not allow this and most Buyers don’t want to commit to improvements before they own the property. But it may be possible.
As implied, exchange proceeds cannot be used to pay for repairs after the closing unless the closing is set up as an improvement exchange. Given real property is sold, then real property must be the replacement property and not materials and labor.
An improvement exchange adds a layer of complexity and a higher Qualified Intermediary (QI) fee. The QI will try to make the numbers work but when less than $30,000 of repairs is needed, it may be best to pay the capital gains tax and use the funds as needed.
What is to prevent the taxpayer from having a contractor paid at closing for work to be done? Hopefully, the QI will let the taxpayer know that should their tax return be audited the IRS will quickly determine the incorrect use of the exchange funds. A penalty may be due, not to mention the tax and interest on the tax to be paid in addition to the time and effort involved with the audit, is not worth it.
Do you qualify for a 1031 exchange? Download this free three page PDF by clicking here.
1031 Exchange Rules
If the government agreed to loan you money and not charge you interest, would you take it? For the smart investor following 1031 exchange rules, the answer is absolutely! This is essentially what the government (Treasury Department and Internal Revenue Service) is doing by allowing taxpayers to defer the payment of capital gains tax after certain transactions, known as the 1031 tax exchange. Completing a 1031 tax exchange is a great way to parlay a taxpayer’s capital gains, but there are plenty of rules to follow in order to do so.
1031 Exchange in Lieu of Foreclosure PLR 201302009
Typically, when a taxpayer sells real or personal property and realizes a gain from the sale, the realized gain is subject to payment of capital gains taxes. One option that taxpayers frequently use to temporarily avoid the payment of capital gains taxes is to enter into a Section 1031 Exchange in lieu of a traditional sale. If a transaction qualifies for Section 1031 treatment, any capital gains taxes that would otherwise be due on the realized gain are deferred.