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Real Estate Tax Advantage #3 - The 1031 Exchange

Whenever you sell business or investment property and you have a gain, generally you will have to pay tax on the gain at the time of the sale. However, the IRS created the Section 1031 exchange (also known as the “Starker exchange” or a “like-kind exchange”) which provides an exception to this rule and allows you to postpone paying capital gains tax from the disposition of a property if you reinvest the proceeds from the disposition into a “qualified like-kind” property.


To illustrate the 1031 exchange, consider the following example:


Assume you buy Property A for $100,000. Also assume that three years later, you sell Property A for $200,000 and use the proceeds to buy Property B for $250,000. Absent a 1031 exchange and assuming your capital gains tax rate is 15% (tax rates depend on income level, the average of which is 15%), you will be obligated to pay $30,000 in capital gains tax, and would only have $170,000 to put down towards the cost of Property B. However, with a 1031 exchange, your capital gains tax is deferred, and you are permitted to apply the entire $200,000 towards Property B.


Do I have a "Like-Kind" Property?


The IRS considers like-kind properties to be of the same nature or character, even if they differ in grade or quality. This is an unnecessarily complicated way of saying that all real property is like-kind to all real property.


There is a two-pronged test for properties to qualify for IRC §1031 tax-deferral treatment.

Both the “relinquished” and the “replacement” properties must be held by the “exchanger” either for investment purposes or for productive use in a trade or business. The exchanger’s purpose and intent in holding the property is the critical test. The use of the property by other parties to the exchange (relinquished property buyer or replacement property seller) is irrelevant.


The Relinquished and the Replacement Properties must also be “like-kind.” The term “like-kind” refers to the nature or character of the property, ignoring differences of grade or quality. For example, unimproved real property is considered like-kind to improved real property, because the lack of improvements is a distinction of grade or quality; the basic real estate nature of both parcels is the same. Treas. Reg. §1.1031(a)-1(b). In essence, all real property in the United States is “like-kind” to all other domestic real property.


What Do I Need to Do?


A 1031 exchange has two main financial requirements: 1) the purchase price of the property/properties you are buying must equal or exceed the sale price of the property/properties that you sell, and 2) if you have a mortgage on your original property, you are required to carry as much debt or more with your replacement property.


To illustrate the rules, assume you have a property with a $100,000 mortgage and that you sell that property for $400,000. To properly complete a 1031 exchange, you must spend more than $400,000 on the replacement property and you must finance at least $100,000 of the cost of the replacement property.


Holding Requirements


A common question arising out of a 1031 exchange is how long must a property be held for investment in a 1031 tax-deferred exchanged? Though the IRS and Treasury Regulations are silent on this issue, a careful analysis of case law yields some principles that can be stated with certainty.


The IRS has issued several rulings stating that if the property a taxpayer seeks to exchange was acquired immediately before the attempted exchange, then the taxpayer will be viewed as having acquired that property primarily to resell for profit, not held for investment.[1] The IRS has also taken the position that if replacement property is disposed of immediately after the exchange, the property would not be viewed as being held for a qualified purpose (investment) under IRC section 1031. Courts have been more liberal on the issue of how long a taxpayer must hold a relinquished property to prove investment intent but tend to agree with the IRS on disqualifying an exchange when the replacement property is disposed of soon after acquisition.


Some tax advisors believe that one-year is a sufficient holding period, for two reasons. First, if investment property is held for 12 months or more, the investor'­s tax returns will reflect this fact in two tax filing years. Second, in 1989, through HR 3150, Congress had proposed that both the relinquished and replacement properties be held for one year to qualify for tax-deferred treatment. Though this timeline was just a proposal, and it was never incorporated into the tax code, some tax advisors nevertheless believe that it represents a reasonable minimum guideline.


Important - Keep in mind that any actual cash you receive from the transaction will be taxed. We recommend you elect a qualified intermediary to handle both ends of the property swap. In the event proceeds are left over after the swap, the intermediary returns the proceeds at the end of a 180-day period, which will be taxed as a capital gain.


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