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.
Real and Personal Property
The property type is very important in determining if it qualifies for a 1031 exchange. The property must be held for trade or business or for investment in order to qualify for a 1031 exchange, which means a personal residence would not qualify (except in rare cases). Additionally, the property being acquired must be of like-kind to that which it is replacing. Luckily, for real estate investors, real estate will generally always be considered like-kind to other real estate, regardless of the use of the property. For example, a warehouse building would be like-kind to a twenty-four door rental. The like-kind definition does get a little bit narrower with personal property, so extra research should be done. Intangible personal property such as TV and radio licenses and franchise rights are eligible for 1031 consideration. Stocks, bonds, and partnership interests, inventory and indebtedness do not qualify for a 1031 exchange.
Timing Considerations
Along with the type of property, timing is another major factor in a 1031 exchange. First, the taxpayer must acknowledge that he/she intends to complete a 1031 exchange before the sale of the property being relinquished. Once the taxpayer acknowledges a 1031 exchange will be completed, two strict deadlines exist, known as the 45-day rule and the 180-day rule. The 45-day rule states that within 45 days of the sale of the property being relinquished, the taxpayer must identify the potential replacement property, preferably to the Qualified Intermediary (QI). The 180-day rule states that within 180 days from the sale of the relinquished property, the taxpayer must have fully acquired the replacement property.
Target Replacement Value
Understanding how much from the sale of the property being sold qualifies for the tax deferred treatment is vital. A taxpayer can defer up to the amount of net sales price from the relinquished property that is reinvested into the purchase of the replacement property. Any amount of the sales price that is not re-invested would be immediately taxable. For example, a taxpayer sells the old investment property for $200,000 and replaces it with a $300,000 property. The entire $200,000 would be tax deferred. Now, assume the taxpayer replaces the property with a $150,000 property; the taxpayer would be able to defer $150,000 and would be responsible for $50,000 in capital gains and recaptured depreciation tax.
Constructive Receipt
The exchange of funds during a 1031 exchange is another important aspect. The IRS does not allow the taxpayer to touch or take control of the sales proceeds from the relinquished property. The reasoning behind this is that the funds are to be used to re-invest in a like-kind property. A QI needs to be engaged to accommodate the 1031 exchange (assuming the exchange is not a pure exchange between two parties), in which the QI will hold the funds from the time of the sale and will then use the funds towards the purchase of the replacement property. QIs hold the funds, following the Prudent Investor Standard, in a segregated, interest bearing qualified escrow account to ensure preservation of principal and liquidity. Disbursement requires a signature from the taxpayer and one from the QI. The taxpayer enters a three way agreement with the bank to place a debit lock on the funds.
When vetting a QI do you want to know what questions the experienced taxpayers ask? Download this free eGuide by clicking on the button below.
