by Reward Realty
on Wednesday, March 14th, 2018 at 12:17pm.
When buying or selling an investment property, you may have questions regarding the capital gains taxes associated with any profits arising from the sale. Did you know that you can defer those taxes? Thanks to our friends at Xchange Soultions, we have some information for you on commonly asked questions.
What is a tax-deferred exchange?
IRC § 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind”, while deferring the payment of federal income taxes and some state taxes on the transaction. The theory behind IRC § 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. rental house exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain. The like-kind exchange under IRC § 1031 is tax-deferred, not tax-free. If and when the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized will be subject to taxation.
What are the benefits of exchanging v. selling?
In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through an IRC § 1031 Exchange, the tax on the gain is deferred until some future date, or even indefinitely. By deferring the tax, you have more money available to invest in another property. In effect, you receive an interest free loan from the federal government, in the amount you would have paid in taxes. Any gain from depreciation recapture is postponed. And, you can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.
What are the general guidelines to follow in order for a taxpayer to defer all the taxable gain?
• The value of the replacement property must be equal to or greater than the value of the relinquished property.
• The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
• The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
• All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.
What are the requirements to properly identify replacement property?
Potential replacement property must be identified in writing, signed by the taxpayer, and delivered to a party to the exchange who is not considered a “disqualified person”. A “disqualified” person is any one who has a relationship with the taxpayer that is so close that the person is presumed to be under the control of the taxpayer. Examples include blood relatives, and any person who is or has been the taxpayer’s attorney, accountant, investment banker or real estate agent within the two years prior to the closing of the relinquished property. The identification cannot be made orally.
What is the 45-day Identification Period and when does it begin?
IRC § 1031 requires that the replacement property be identified within 45 days of closing on the relinquished property. This identification period is strictly enforced and violation will defeat the tax deferral.
What is the 180-day exchange period and when does it begin?
IRC § 1031 requires the replacement property be purchased within 180 days of closing on the relinquished property OR the date the taxpayer’s tax return is due, whichever date is first. The purchase date is considered to be the closing date. For tax return due dates that fall before the 180 days, a tax return extension can be filed. However, a taxpayer can never amend their return for extension purposes.
What if the taxpayer cannot identify any replacement property within 45 days, or close on a replacement property before the end of the exchange period?
Unfortunately, there are no extensions available. If the taxpayer does not meet the time limits, the exchange will fail and the taxpayer will have to pay any taxes arising from the sale of the relinquished property.
Is there any limit to the number of properties that can be identified?
There are three rules that limit the number of properties that can be identified. The taxpayer must meet the requirements of at least one of these rules:
• 3-Property Rule: The taxpayer may identify up to 3 potential replacement properties, without regard to their value; or
• 200% Rule: Any number of properties may be identified, but their total value cannot exceed twice the value of the relinquished property, or
• 95% Rule: The taxpayer may identify as many properties as desired, but before the end of the exchange period the taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair market value of all the identified properties.
Is there an extension allowed to either the 45-day period or the 180 period?
The IRS generally does not allow extensions for either the 45-day period or the 180-day period. In rare instances, such the time Florida had several disastrous hurricanes in a row, the IRS may grant extensions for taxpayers located in nationally declared disaster areas.
This blog entry is intended to be used as guidance for some initial questions you might have regarding 1031 exchanges. If you are interested in learning more or using this program, we advise you to speak with a 1031 intermediary who can answer any additional questions you might have regarding the process.