One of the consequences of selling an appreciated investment, be it a stock, collectibles or investment real estate, is the assessment of taxes on any capital gains. In the case of real estate, tax liability upon disposition may also include depreciation recapture.
Fortunately, Section 1031 of the Internal Revenue Code (IRC) provides a safe harbor that enables investors to defer making capital gains tax payments if they promptly replace the property sold with “like kind” assets, in accordance with the IRC rules. These are called 1031 exchanges. Below is an overview of the 1031 exchange rules and the process of receiving tax benefits.
As of January 1, 2018, the IRS determined that, “exchanges of machinery, equipment, vehicles, artwork, collectibles, patents and other intellectual property and intangible business assets generally do not qualify for nonrecognition of gain or loss as like-kind exchanges.” Like-kind exchanges now apply only to real property not held primarily for sale, and those using 1031 exchanges for personal or intangible property must have sold the exchanged property before or on December 31, 2017.
The like-kind definition is also construed very broadly for real estate (i.e., a commercial building that is exchanged for an apartment, farmland, or oil and gas royalties). Speak with your accountant or tax advisor to see if your exchange qualifies as a like-kind exchange.
Assuming all of the rules are strictly followed, the investor’s tax basis in the sold property will carry over to the replacement property, and the capital gains tax and depreciation recapture that ordinarily would be assessed at the time of sale will instead be levied when the replacement property is sold.
So how can you avail yourself of this tax benefit? To get started, you will first need a qualified intermediary (QI), also known as an exchange accommodator, to hold your sale proceeds for the duration of the exchange transaction. QIs are often affiliated with banks or title companies, their reputations will be evidenced by an established track record, and they should not be related to the exchanging party. Having a QI is critical, because any sale proceeds disbursed directly to the investor cannot be part of the 1031 exchange.
Next, you will enter into contracts to sell your property and to buy one or more replacement properties with the proceeds. The QI will provide you with language to be included in the purchase and sale contracts to indicate that an exchange is taking place. In a traditional exchange, your sale will happen first. When you close, the QI will hold all of your net sale proceeds until you are ready to acquire your replacement property.
You have 45 days from the date your sale closes to identify potential replacement properties. You may identify multiple properties, either together or in the alternative. However, in order to completely defer your taxes, the value of all of the replacement property you acquire must be greater than or equal to the value of what you just sold. This includes the amount of any mortgage.
Here’s an example. If you have a $500,000 mortgage on your property, and you sell it for $1.5 million, your replacement property must be worth at least $1.5 million, even though you only have $1 million in cash proceeds. It is prudent to buy slightly more expensive replacement property, as some transaction costs may be ineligible for the exchange under the IRC.
In the example above, your replacement property may be another $1.5 million (or greater) property, two $750,000+ properties, or even three $500,000+ properties. The rules permit you to identify alternatives in case one or more of your options does not work out.
Whatever you choose, you must acquire all of your replacement property within 180 days of your initial sale. Any proceeds that are not reinvested in the 180-day exchange period will be returned to you, and you will be subject to any taxes due on that amount.
As noted above, the 1031 exchange rules are very specific, and this article merely provides an overview. The rule that is not in the tax code is perhaps the most important: you should consult with your accountant or a knowledgeable tax advisor before undertaking any exchange.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Investing in Commercial Real Estate and The Legal & Tax Aspect of Investing: Asset Protection; Estate Planning, and Tax Efficiency. This is an updated version of an article originally published on June 21, 2016.]
Tracy Treger is Principal at Syndicated Equities. Tracy helps high net worth individuals and family offices to profitably invest in real estate. She also assists investors in identifying appropriate replacement property to complete tax-deferred exchanges under Section 1031 of the Internal Revenue Code. Drawing upon her 20 years of legal experience in the areas of…
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