Learn about the basics of §1031 exchanges and the role a qualified intermediary plays in the process.
§1031 of the Internal Revenue Code (also referred to herein as the “IRC” or “Code”) is a section of the Code which allows a taxpayer to defer the capital gain and depreciation recapture which would otherwise be realized at the time of sale of appreciated real estate which is used in a trade or business or held for investment.
As you might expect, there are conditions which apply and which must be satisfied in order to qualify for the tax deferral. A properly structured exchange will allow you the option to keep all of your money (equity) working for you instead of sending a payment to the U.S. Treasury.
In a simultaneous exchange example, both the relinquished and replacement property titles are transferred at the same time. While it is true that there must be an exchange, there is no requirement that the transfers must occur at the same time.
This is the most common type of exchange. In a deferred or forward exchange, the replacement property must be identified within 45 days from the transfer of the relinquished property and acquired within 180 days after that day or the due date (with extensions) of the taxpayer’s federal income tax return for the year in which the relinquished property was transferred. Both the 45-day and the 180-day time periods begin on the date the relinquished property is transferred.
In some cases, a taxpayer will want to make improvements to the replacement property and have the cost of these improvements included in the exchange value of the replacement property. These types of improvement exchanges are allowed, subject to meeting certain conditions. If you are considering an exchange with improvements, it is important to discuss the proposed project with us to make sure the correct exchange structure is in place prior to starting the project.
Reverse exchanges are a valuable tool which allow a taxpayer the ability to complete an exchange when the closing of the replacement property will occur prior to the sale of the relinquished property(ies). The IRS acknowledged this as an acceptable method of completing an exchange and created a “safe harbor” for doing so when they issued Rev. Proc. 2000-37. The structure used for a reverse exchange is different than the one used in a traditional forward exchange. If you think aa reverse exchange may be the right strategy for you, contact us and we will provide additional details about setting up a reverse exchange.
The role of the qualified intermediary was established in the four “safe harbors” resulting from the 1991 Treasury Regulations for tax deferred exchanges under §1031. The first of the four safe harbors allow a taxpayer to avoid actual, or constructive, receipt of money or other property for purposes of completing an exchange by employing a qualified intermediary, or “QI”.
Under the regulations, the QI facilitates the transfer of the taxpayer’s relinquished property to qualified replacement property. The QI holds the proceeds of the sale in escrow pending the identification, and later purchase, of the replacement property to complete the exchange.
The regulations also set forth certain requirements related to who can serve as a QI. The QI is required to maintain “an arm’s length” relationship with the taxpayer. Consequently, anyone with a contractual or fiduciary relationship to the taxpayer is ineligible to act as the QI.
*Accountants, CPA’s, attorneys, real estate agents/brokers and wealth advisors are ineligible to serve as a QI*
The Tax Cuts and Jobs Act of 2017 modified the types of property which would qualify for tax deferral under §1031, specifically eliminating personal property from the list of eligible property types. Thus the tax deferral available under §1031 is generally limited to exchanges of real estate.
There are two important requirements related to the timing of an exchange.
A taxpayer has 45 days to identify replacement property and 180 days (or the due date for the taxpayer’s return, whichever occurs first) to complete an exchange. Both dates run concurrently and begin with the day following the closing of the sale. You can use this calculator to calculate your 45th and 180th day. Keep in mind: if your relinquished property sale occurs after October 15th in any given year and you are a calendar year taxpayer, you will need to extend the due date for your tax return to obtain the full 180 days.
Investing has one simple goal – to increase the value of the investment. A §1031 exchange is one of the most important tools available for increasing the value of your investment.
A properly structured §1031 exchange can:
- Defer capital gain taxes typically due upon a sale.
- Defer depreciation recapture which results from a sale.
- Reduces debt on future purchases of real estate.
- Allows for maximum reinvestment, increasing the return to the investor.
The tax savings which result from a properly structured exchange is the equivalent of an interest free loan from the government with no term. If the investor passes the property through their (eliminate the spacing)estate, the heirs receive a “step up” in basis which can eliminate
the tax burden for future generations. Other benefits of an exchange versus a sale include:
- Preserving the equity from a sale allows the investor the opportunity to acquire a larger property, increasing the cash flow and depreciation.
- The ability to diversify into multiple properties.
- The ability to centralize management creating additional efficiencies
- In some instances, the ability to trade from non-depreciable property into depreciable real property, creating additional cash flow.
The first step is to estimate your tax savings.
Secondly you need to ensure your property qualifies for an exchange. Under the 2017 Tax Cut and Jobs Act, §1031 Exchanges are limited to real estate.
Third, who is performing the exchange? Is there a single owner? Individual? Partners? A limited liability company? How you answer these questions is critical to reaching the desired result. Advance planning is a must.
Finally, how much do you intend to reinvest? Is the goal 100% tax deferral? Does the investor intend to receive any cash at closing?
You should always consult with your legal and tax professionals regarding your specific situation and tax deferral opportunities. Our experts will work with you and your advisors to understand the critical details of your transaction, helping you to achieve the desired result.
While it is possible to structure a §1031 exchange between a Seller and Buyer of real estate, the better alternative is to utilize the “Safe Harbor” established by the IRS. The Safe Harbor has been in existence for over 30 years and provides a reliable means of achieving the desired tax deferral.
The Safe Harbor regulations set forth a recommended process for structuring a tax deferred exchange. Key to the tax deferral are the following requirements:
- The taxpayer must have an intent to do an exchange.
- The taxpayer can only receive qualified real estate as part of the exchange. Related to this issue is the requirement that during the exchange period the taxpayer must avoid actual or constructive receipt of the proceeds of sale of any relinquished property.
- The taxpayer must identify qualified property and exchange qualified property during the applicable time periods.
When you hire §1031 Exchange Intermediaries to assist with your exchange transaction, we will make sure you are aware of all of the above critical information and assist you in navigating the entire exchange process from start to finish.
Once your exchange is completed you will receive a complete set of documents designed to evidence your compliance with Safe Harbor regulations and provide an important document trail should it become necessary to evidence your exchange.
Knowing how much you’ll save can help determine if a §1031 Exchange is right for you. Calculate your tax savings today by using our capital gains tax calculator.
Are you ready to maximize earnings on your real estate investment? Fill out the contact form below, and one of our representatives will reach out to you shortly.
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