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 Rules
Property type: The IRS is very clear in its rule that states that the property being sold (referred to as the relinquished property) must be of like-kind to the property that is replacing it (referred to as the replacement property). For the purposes of discussion, real estate will always be considered like-kind to other real estate, regardless of its condition and use. Personal property is a bit restrictive where the asset group or product class must be the same to qualify for 1031 treatment.
Property use: In order to be considered for a 1031 exchange, the rules stipulate that the property must be held for the proper intent or productive use in a trade, business or for investment. A taxpayer cannot use his/her personal residence in a 1031 tax exchange, unless it was held initially as a rental for two years, then at least two of three remaining years out of five prior to selling. In addition, stocks, bonds, indebtedness, inventory and partnership interests do not qualify.
Timing: There are three timing aspects that the taxpayers need to be aware of and follow in order for the 1031 tax exchange to be considered valid. First, at the time of the sale of the relinquished property, the taxpayer should identify that he/she plans to use this property in a 1031 exchange. Attempting to notify the appropriate party after the sale is not allowed. Second, the replacement property must be found within 45 days of the date of sale of the relinquished property, and the appropriate party as in the Qualified Intermediary must be identified in writing no later than 11:59 PM on the 45th calendar post closing. Failure to identify and notify will render the exchange invalid. Lastly, within 180 days of the sale of the relinquished property, the taxpayer must complete the acquisition of the replacement property. The IRS is extremely strict about these deadlines, and will only grant an exception in the case of a natural disaster as posted on the IRS website.
Qualified Intermediary: In most instances with real estate, the sale of the relinquished property and the purchase of the replacement property do not happen simultaneously. This is known as a deferred tax exchange, and the IRS rules state that the taxpayer cannot take possession of any of the sales proceeds from the relinquished property, unless those proceeds become taxable. Because of this, a taxpayer must use a qualified intermediary, who acts to facilitate the transactions and will hold the sales proceeds until the new property is found and purchased. The qualified intermediary exists to ensure that all of the IRS rules are followed and that the taxpayer does not take control of any of the sales proceeds.
Tax-deferred amounts: The IRS allows a taxpayer to defer up to 100 percent of the recaptured depreciation, federal, state and local capital gain taxes on the sale of the relinquished property. To do so, the replacement property may be purchased using 100 percent of the relinquished property’s sales proceeds. In other words, as long as the entire sum of the sales proceeds are reinvested in the replacement property, one hundred percent of the capital gains tax is deferred. If the replacement property was purchased for less than 100 percent of the sales proceeds, only the total of the purchase price would be tax deferred, while the remaining would be taxable.
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