The use of the tax free exchange is becoming an increasingly popular tool among real estate investors and owners of construction equipment, business aircraft, artwork and gold and silver bullion who are looking to reinvest 100 percent of the sales proceeds and debt retired from the sale of a property. The tax free exchange, also known as a 1031 exchange, is ultimately a tax delayed exchange because it allows the taxpayer to delay the payment of tax on any capital gains realized and recaptured depreciation until the replacement property is sold. Completing a tax free exchange is not a simple process and there are several points that need to be known.
1031 Exchange Timelines
In order to qualify for a tax free exchange, timing is very crucial. All parties to the exchange must be notified of the 1031 tax exchange. This is accomplished by including the assignment language in the Purchase and Sale Agreement and a Notice of Assignment at time of closing. Next, upon the sale of the property, the taxpayer must identify within 45 days a replacement property they intend to purchase with the exchange proceeds and debt retired from the sale in a forward exchange. In a reverse exchange where the replacement property is acquired before the sale, the taxpayer has 45 calendar days to identify to the Qualified Intermediary the property that will be sold. Within 180 days from the date of the sale, the taxpayer must have completed the transaction and be in possession of the new replacement property. These are extremely stringent deadlines and are typically only extended in the instance of a natural disaster, per the IRS website.
Real and Personal Property
The types of properties involved in the tax free exchange must be like-kind to each other. Real estate is almost always considered like-kind to other real estate regardless of its use (commercial, residential, etc.). Personal property, such as gold and silver bullion, vintage cars, artwork, business aircraft and furniture must be exchanged for like kind or like class assets. This means bullion must be exchanged for bullion, cars for cars, oil painting for oil painting, aircraft for aircraft and furniture for furniture. To qualify, both the property being sold and the property being acquired must be productively held for use in a trade, business or for an investment. A personal residence, stocks, bonds, indebtedness, inventory and partnership interests do not qualify for a tax free exchange.
Investment properties can be converted to a primary residence once held as an investment. To learn more, access a brief article on Converting Rental to a Primary Residence.
The IRS allows for the deferment of capital gains tax on 100 percent on the realized capital gain and recaptured depreciation triggered from the relinquished property sale. The exchange theory is if a taxpayer is reinvesting the proceeds from the sale of the relinquished property within 180 calendar days, their economic position has not changed; they have not received the benefit of access to the net equity or cash and reduced debt level. An example is shown below to illustrate a 1031 tax free exchange.
Example: Maurice has decided to enter into a 1031 tax free exchange by selling his existing investment property for $200,000. He has found a replacement property for $250,000. Because the replacement property is being purchased for more than the sales price of the relinquished property, Maurice would be able to defer the entire amount of capital gains tax that would otherwise be due on the sale. Now, assuming the replacement property was being purchased for $175,000, Maurice would be able to defer the capital gains tax on the $175,000 but would be immediately responsible for any tax due on the remaining $25,000 that is above the purchase price of the replacement property. This is the case because he would not be reinvesting that last $25,000 into the new investment.
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