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1031 Exchanges - The Smart Way To Buy Investment Property
By Jack Cutone
The 1031 tax deferred exchange is a powerful tool.
In a nutshell, it is an IRS approved method that allows you to sell
your real estate property and reinvest in another property (or
properties), deferring federal (and most state) capital gains taxes.
When the exchange meets the 1031 criteria (more on this below), the
taxes are deferred until sometime in the future, usually when the
newly acquired property is sold. For individually held investments,
the deferral can continue through any number of exchanges, even until
the tax liability passes into the individual's estate.
The intent of the delayed property exchange is that you have an
actual continuation of your old property investment into your new
replacement property. Needless to say, this is a terrific way to
continue the growth of your original investment while minimizing the
tax consequences.
* Next 37 17 investors only!
Requirements
As you might imagine, the IRS rules governing a 1031 exchange are
quite detailed and specific. At a high level however, three
conditions must be met to accomplish the exchange:
- The properties exchanged must "qualify" and be of "like-kind."
The IRS sorts real estate into four classifications: Personal
Property (for personal use), Dealer Property (primarily for sale),
Business Property and Investment Property. Only the last two -
Business and Investment - qualify for 1031 tax deferral; the first
two do not. That's the "qualify" part.
"Like-kind" refers to your use of the property (not its grade or
quality), and both the property received and the property sold must
be of "Like Kind." An investment property exchanged for another
investment property, for example, would qualify. Keep in mind as
well that it doesn't matter what the other party does or did with the
property - it's your use that determines the classification.
- The time requirements must be strictly followed.
The replacement property (the one you are planning to purchase) must
be "identified" within 45 days of closing on the relinquished
property (the one you are selling). In identifying, the replacement
property must be unambiguously described (e.g. with a street address
or legal description).
Also, the replacement property must be received within 180 days of
closing or on the date that the tax return of the taxpayer is due,
including extensions, whichever is earlier.
- There must be an actual exchange, not a transfer of property for
money only.
Two Important Things to Keep in Mind
- Trade Even or Up In Value. The property you wish to acquire
should
have a value equal to, or more than, the relinquished property. In
other words, all of the proceeds from the relinquished property sale
should be invested in the replacement property. If you don't do this,
the transaction may still qualify as a 1031 exchange, however the
unused proceeds (known as "boot") will be taxed on their face value
at the capital gains tax rate.
- Exchange or Sale. Section 1031 requires an actual exchange of
properties. If you simply sell your property and reinvest the money
in another property - even if it's a simultaneous close - you will
not qualify for exchange treatment. This type of transaction will
result in something called "Constructive Receipt."
Constructive receipt occurs when you have the funds in a position in
which you may draw on them, direct their usage, or give notice of
intention to withdraw. In other words, with a 1031, you must not have
control of the funds.
One of the primary ways that you avoid constructive receipt is with a
written contractual agreement with a Qualified Intermediary. The
Qualified Intermediary, for a fee, acts to facilitate the deferred
exchange by entering into an agreement to exchange the properties.
Under this agreement, the Qualified Intermediary sells the
relinquished property, acquires the replacement property, and
transfers the replacement property to the exchanger.
This is just a brief overview, and of course there are many more
details involved in getting from start to finish with this process.
Keep in mind as well that a 1031 tax deferred exchange is not some
kind of slick loophole - the government is deliberately subsidizing
your purchase as encouragement to keep your money in the marketplace.
It truly is a win-win for both you and the IRS.
The bottom line is that with a 1031 exchange, you as the investor
have an increase in purchasing power (thanks to the deferral of
capital gains tax) with which to buy real estate. Frankly, it
doesn't get much better than that.
Jack Cutone is the founder of United Asset Trading Company, LLC, and
is the Managing Partner. The company's focus is on intermediary
services for 1031 Exchanges, and is based in Marlborough,
Massachusetts. For more information visit
www.1031uatc.com, or call
508-481-8893.
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