As a general rule, anytime you sell property, the gain you receive as a result of the sale is subject to capital gains taxes. For example, if you purchased a property five years ago for $100,000 and now wish to sell it for $150,000, you would be subject to paying capital gains taxes on the gain of $50,000. One strategy that allows you to defer capital gains is to enter into a 1031 Exchange. Section 1031 of the Internal Revenue Code can provide an effective mechanism for deferring the payment of payment of capital gains taxes if the 1031 exchange guidelines are followed.
Proper Intent
In order to qualify for a 1031 exchange, the properties exchanged must be held for productive use in a trade or business, or for investment. Certain specific exclusions apply such as a personal residence, stocks, bonds, notes and other securities. Under the 1031 exchange guidelines, the property exchanged must be of “like-kind”. In some cases, determining that the property is of “like-kind” is simple. For example, exchanging an apartment complex for another apartment complex may easily qualify as a “like-kind” exchange. Other situations are not as clear. The exchange of U.S. $20 gold coins (numismatic-type coins) for South African Krugerrand gold coins (bullion-type coins) was disallowed by the I.R.S., for instance, while the exchange of gold bullion for Canadian Maple Leaf gold coins was determined to be a “like-kind” exchange.
1031 Exchange Timelines
In order to make use of a 1031 exchange, you are also required to locate and identify a qualifying replacement property within 45 days of the sale of the original property. The 1031 exchange guidelines then allow you a total of 180 days to complete the exchange. Under the rules of a Reverse 1031 Exchange, you may locate the replacement property first and then sell the original property; however, the time allowed to identify the property to be sold and to complete the sale remain the same.
Role of Qualified Intermediary
A 1031 exchange transaction must be handled by a Qualified Intermediary in order to satisfy the 1031 exchange requirements. The Qualified Intermediary takes possession of the property to be sold and transfers it to the new buyer as well as takes possession of the replacement property and transfers it to the original seller. All funds used in the transaction must also pass through the Qualified Intermediary who then distributes them upon completion of the transaction.
Capital Gains
The capital gains tax rate fluctuates and is dependant on the tax payer’s personal income tax bracket. Imagine that the applicable tax rate is 15 percent — the minimum rate for 2011. In the above example, you would owe capital gains taxes in the amount of $7,500 if you sold the property outright. By entering into a 1031 Exchange, you can defer payment of the $7,500, thereby allowing you to re-invest the funds immediately.
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