There are many potential benefits of owning real estate investment property. One specific benefit is the ability to defer gains when buying and selling properties. You may find yourself in a position where the value of your property is worth significantly more than the original purchase price and cost of improvements. Through certain transactions, investors can save substantially on taxes in the present by delaying capital gains.1 Most investors will eventually cash out and pay taxes, but by using the strategies outlined in this piece, you can continue to delay the tax obligations.
By using what is known as a 1031 or ‘like-kind’ exchange, an investor can dispose of one property and acquire another resulting in a tax-deferred transaction.1 The regulations of these transactions, as well as increased IRS scrutiny, require taxpayers to plan diligently and take proper steps to successfully defer the capital gains. Due to the recent change in tax legislation, the like-kind exchange rules only apply to real property2 and must meet the qualified use test as defined by the IRS. Under this test, the taxpayer must have held the surrendered property and intend to hold the acquired property for investment, trade or business purposes.3 These rules are applicable whether the properties are owned outright or through a partnership.4 Property that is held or will be held for personal use generally does not qualify for this special tax-deferred treatment.
The most common approaches to deferring the gains on like-kind property exchanges are known as delayed exchange5, simultaneous exchange6 and reverse exchange.7 The delayed like-kind exchange is the most commonly used strategy and occurs when the original property is relinquished prior to acquiring the replacement property. In doing so, the sale of the relinquished property is initiated, and the proceeds must be held in a binding trust. Using this approach, the replacement property must then be identified within 45 days and purchased within 180 days.5
As the name implies, the simultaneous exchange approach involves closing on the original property and replacement property transaction simultaneously.6 This approach can be difficult to implement as aligning the closing dates is often not feasible.
You may unexpectedly find an investment opportunity and be in a situation where the replacement property must be acquired before the original property can be sold. In other words, you buy first and sell later. This approach, called a reverse exchange, has additional complexities. As an exchange is considered the continuation of the original investment, the investor cannot own both the relinquished and the replacement properties at the same time. To facilitate the reverse exchange, the title to either the relinquished or the replacement property is held by an Exchange Accommodation Titleholder (EAT) until the relinquished property can be conveyed to a buyer.8 As with a delayed exchange, Revenue Procedure 2000-37 set forth by the IRS allows the EAT to “park” title for a maximum of 180 days. If the replacement property is parked with the EAT, the relinquished property must be designated in writing within 45 days.9
In any situation, there are certain rules that must be followed under each of those three strategies.
1. Like-kind property: As previously mentioned, you can exchange almost any type of property, so long as the original and replacement property are held for investment or business use, and not personal use.3
2. Greater or equal value: If the replacement property is not of greater or equal value, then a portion of the gain will be taxable upon sale.5 Acquisition costs, such as inspections and broker fees, all apply toward the cost of the new property.
3. Must not receive “boot”: For the exchange to be completely tax-free, a taxpayer must not receive “boot.” In other words, you can carry out a partial 1031 exchange, in which the new property is of lesser value, but this will not be 100 percent tax free. The difference in property values is called “boot.” Any boot received is taxable to the extent of gain realized on the exchange. This option is often used when a seller wants to make some cash and is willing to pay some taxes to do so.10
4. 45-day identification window: The property owner has 45 calendar days, post-closing of the first property, to identify up to three potential properties of like-kind.4
5. 180-day purchase window: It’s necessary that the replacement property be received and the exchange completed no later than 180 days after the sale of the original property.
If you find yourself exchanging real estate property, we suggest thoroughly evaluating your options and diligently structuring the transaction for successful execution. Your Exencial team is available to assist in proper planning. If you have additional questions, please reach out to your Exencial advisor or feel free to contact me directly at awinsett@ExencialWealth.com.
1. The Balance – How to do 1031 exchanges to defer taxes
2. Investopedia – Real property
3. Investopedia – Like-kind property
4. Investopedia – Section 1031
5. Investopedia – 1031 exchanges: 10 things to know
6. Real Wealth Network – How to do a 1031 exchange: Rules & definitions for investors 2019
7. Investopedia – Reverse exchange
8. Investopedia – Qualified exchange accommodation arrangements
9. Internal Revenue Service – Revenue Procedure 2000-37
10. Investopedia – Boot
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