As the old adage goes… the two things you can never seem to escape from are death and taxes.
Often referred to as the “1031 Tax Free Exchange”. The truth is …. It is not tax free but tax deferred. One of the least understood tax relief provisions of the Internal Revenue Code (IRC) is the tax-deferred exchange under IRC Section 1031. The 1031 exchange transaction is complicated and must withstand the IRS scrutiny. If the transaction is not completed properly, you will be responsible for the taxes you were trying to avoid paying at the time of the transaction and perhaps some imposed penalties.
Although the tax shelter days are basically gone for real estate investors, and the passive loss regulations work against them, the tax-deferred exchange lives on as a viable and excellent alternative to defer income taxes upon the sale of real estate. An exchange is broadly defined as a reciprocal transfer of real property that has certain tax advantages over a sale. Definite procedures must be followed in order to qualify the transfer as an exchange.
The choice of a tax-deferred exchange affords the seller/taxpayer an exceptional opportunity upon selling the property. A tax-deferred exchange can best be defined as a sale without immediate tax implications with a window to replace the property with like-kind property and reduce the basis of the replacement property by the deferred gain, thereby deferring the tax to a future date.
Sellers should view tax-deferred exchanges as a viable tax planning tool. Properly structured tax-deferred exchanges can defer significant gain and the corresponding tax liabilities. Most important to remember is that sellers do not have to enter into a simultaneous exchange which, more often than not, is nearly impossible to effectuate. Tax-deferred exchanges under Section 1031 of the IRS code allow taxpayers a reasonable period of time in which to complete a tax-deferred transaction.
When seeking replacement property, it is advantageous to identify more than one property in the event that the primary property cannot be acquired. The regulations provide that the seller must meet any one of the following three alternatives for property identification:
- One to three properties without regard to the fair market value.
- Any number of properties, provided that the aggregate fair market value does not exceed 200 percent of the relinquished property.
- Any number of properties, as long as the acquisition of the replacement property represents 95 percent of the identified properties. (e.g., If you identify $2,000,000 in replacement property and purchase $1,900,000.)
Of the three alternatives, the “three property rule” is the one most sellers choose.
For more information on 1031 Exchanges, consult your qualified Real Estate Professional or visit: http://www.law.cornell.edu/uscode/text/26/1031
Howard J. Corr, CCIM