A tax deferred exchange is a method by which a taxpayer trades property, held for investment or business purposes, for replacement property resulting in a deferral of tax on the transaction. Often investors do not realize that taxation on income or investment property differs substantially from that of a primary residence. If an investor sells appreciated property that qualifies for preferential treatment under Internal Revenue Code Section 1031 (IRC §1031) the property is treated quite differently. IRC §1031 states:
No gain or loss shall be recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of like-kind.
Therefore, an investor using IRC §1031 can exchange bare land for a rental home, a warehouse for an apartment complex, or an office building for a shopping center. The primary use of the property is a key factor in determining qualification for tax treatment.
1031 exchanges are often referred to as “as free exchanges” as the transaction itself is not taxed. Section 1031 of the Internal Revenue Code provides an exemption from current recognition of realized gain, providing that the requirements of the IRC are carefully met.
Advantages & Disadvantages
The primary advantage of a tax deferred exchange is that the taxpayer may dispose of property without incurring any immediate tax liability. this allows the taxpayer to have more overall investing power by deferring taxes and therefore enabling greater leverage, as opposed to paying the tax liability.
Often the capital gain taxes are deferred indefinitely because many investors continue to exchange from one property to the next, increasing the value of their real estate investments with each exchange. In addition, the tax liability is forgiven upon the death of the taxpayer, which means that the taxpayer’s heirs receive a stepped up basis on such inherited property. That is to say their basis become the fair market value of the inherited property at the time of the taxpayer’s death.
Before deciding whether or not to engage in an exchange, the taxpayer should carefully analyze all of his or her options. Additional benefits include:
- Consolidate or diversity investments
- Eliminate management problems
- Increase cash flow
- Relocate business investments
- Greater appreciation through leverage
- Estate Planning
The taxpayer should also consider the disadvantages of a tax deferred exchange. This includes a transferred basis in the newly acquired property, as well as additional transactional costs of completing an exchange. Another disadvantage is that the taxpayer may not personally accept any of the proceeds from the sale of the relinquished property or they may incur tax consequences.
Before deciding whether or not to engage in an exchange, the taxpayer should carefully analyze all of his or her options. Once all of the factors have been considered, a taxpayer may, or may not, decide to engage in a tax deferred exchange.
Tips for Success
To ensure a successful IRC Section 1031 Exchange, please pay careful attention to the following areas:
- Contact Accommodator
- Immediately upon deciding to perform an exchange, contact a 1031 Exchange Accommodator. The accommodator works closely with all parties, including the closing office, real estate agent, attorney and accountant.
- Identification Period
- Within 45 calendar days of property closing, the Exchanger must provide a signed letter identifying the replacement properties to either the Qualified Intermediary or closing company.
- Replacement Period
- Within 180 calendar day following the closing of the first property or the tax filing date, whichever is sooner, all replacement properties must be acquired.
- Trading Up
- The net market value and equity of the property sold must be equal to or greater in the replacement property to defer 100% of the taxes. In a situation where you do not meet this value, taxes must be paid on the difference.
- Same Taxpayer
- The taxpayer who sold the relinquished property must also acquire the replacement property.
Tax deferred exchanges require advanced tax planning and attention to structuring. Numerous opportunities are available when engaging in a tax deferred exchange as an investment strategy. The application of an IRC Section 1031 Exchange to a particular situation can only be determined after a careful study of the facts and circumstances surrounding the the transaction.
If you are thinking about a 1031 Exchange or are looking for an Exchange Accommodator, contact us and we’d be happy to help you.