Capital Gains Tax Deferral for the Investor and Dealer

Given today’s real estate market where the lure to fix and flip is a part of mainstream reality TV, a question often in the mix is whether a 1031 exchange will defer the capital gains taxes? With the newly renovated property, the next step is to either hold or resell. If the property is resold within a year of the purchase, the short term federal and state capital gains taxes can eliminate upwards of 40 percent of the gross profit. Can a 1031 exchange defer these taxes is now a question the investor or dealer must understand.

Intent and Facts

The Internal Revenue Code Section 1.1031 allows taxpayers to defer the gain or loss when property held in a trade, business or investment is exchanged for like-kind property held in a trade, business or investment. The proper intent to qualify for a 1031 exchange is that the property is held in a business or investment, unlike inventory held on the shelf at the auto parts store for profit or resale. Facts supporting proper intent include:

  • how long the property was held
  • whether or not it was rented
  • how was it itemized on the taxpayer’s federal tax return
  • amount of personal use

The shorter the hold, the more substantial the facts will need to be. The IRC does not specify a hold time, but the Internal Revenue Service has stated in writing that two years is sufficient.

Investor vs. Dealer

Enter another set of facts to understand: whether the taxpayer is an investor or a dealer. Before rationalizing the taxpayer is always an investor, it is important to understand how the courts are determining this outcome. An investor with the intent to defer gain in a 1031 exchange will hold the property to allow it to season as an investment, including renting the property at fair market rent. Personal use is limited to fourteen overnights per year. To be fully compliant with Revenue Procedure 2008-16, the property will be held for two years and in each of those years, the property will be rented fourteen overnights. The replacement property will also be held for two years and in each of those years, the property is rented out a minimum of fourteen overnights per year at fair market rent.

A dealer or the taxpayer who owns multiple properties can fix and flip, along with 1031 exchanges, given the two are accounted for separately. The court considers the following facts as provided by Klarkowski v. C.I.R., T.C. Memo. 1965-328:

  1. The purpose for which the property was initially acquired
  2. The purpose for which the property was subsequently held
  3. The extent to which improvements, if any, were made to the property by the taxpayer
  4. The frequency ,number and continuity of sales by the taxpayer
  5. The extent and nature of the transactions involved
  6. The ordinary business of the taxpayer
  7. The extent of advertising, promotion or other active efforts used in soliciting buyers for the sale of the property
  8. The listing of the property with brokers
  9. The purpose for which the property was held at the time of sale

The hard right decision, in the view of this qualified intermediary, is to pay the tax rather than pushing the envelope of a rationalized 1031 exchange. The surprise of an IRS audit is best offset with facts that support the proper intent.

Related articles of interest:

1031 Exchange: Land for Rental Property

Chris Kim was referred to Atlas 1031 Exchange by his Realtor to accommodate the 1031 exchange of vacant land for a rental property in different cities in Texas. The old or relinquished property was sold and the exchange proceeds were wired to an escrow account established under his tax identification number in Leesport, Pennsylvania with VIST Bank. Chris identified a couple of properties as potential replacement property by the 45th calender day post closing. After negotiating the purchase contract for rental property, the closing was held and the exchange proceeds were wired the day before the closing.

The exchange went smoothly allowing the capital gains to be deferred and replacement property acquired before the 180th calendar day.

“Andy made the exchange an easy process.  At first, I was hesitant of working with someone I hadn’t met. But with each conversation, he answered all of my questions and did what he said he would. I found him patient, proactive in making me aware of decisions to be made in advance of the time lines. I hope to work with Andy and Atlas 1031 Exchange again and happily refer them to anyone who could use their fine services.”

Chris Kim
Houston, Texas

 

Capital Gains Tax Deferral

Deploying a capital gains tax deferral strategy merits additional attention given the pending federal changes effective January 1, 2013. Taxes on ordinary income will increase from 35 percent to 43.4 percent for earners in the highest bracket.  The long-term capital gain rate will increase from 15 percent to 23.8 percent including the new 3.8 percent “health care tax” on interest, dividends and other passive income earned by individuals with income more than $200,000 per year, or $250,000 for married taxpayers. The estate and gift tax will also change. The current estate and gift tax exclusion is $5 million with any excess subject to a federal estate tax of 35 percent. Effective in 2013, the exclusion returns to $1 million with the maximum estate and gift tax increasing to 55 percent.

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1031 Exchange: Land for Rental Property

Chris Kim was referred to Atlas 1031 Exchange by his Realtor to accommodate the 1031 exchange of vacant land for a rental property in different cities in Texas. The old or relinquished property was sold and the exchange proceeds were wired to an escrow account established under his tax identification number in Leesport, Pennsylvania with VIST Bank. Chris identified a couple of properties as potential replacement property by the 45th calender day post closing. After negotiating the purchase contract for rental property, the closing was held and the exchange proceeds were wired the day before the closing.

Continue reading