1031 Exchange
Internal Revenue Code Section 1031 allows you the opportunity to defer capital gains taxes owed upon the sale of investment or income property by exchanging the property for other like-kind property.
Capital gains are the difference between what a property sells for and the "adjusted basis" in the property. When investment property is purchased, the purchase price becomes the initial cost basis. If you make capital improvements to the property, the cost of those improvements will increase the basis in the property, adjusting the basis upwards. Depreciation is a benefit to owning investment property which allows for a yearly deduction of a portion of the value of the property improvements.
Gain from appreciation (the increase in your property value) is taxable currently at a maximum of 15%. However, the gain from the depreciation is taxed at 25% depreciation recapture. In addition, most states will charge state tax.
A myriad of court cases and IRS rulings have established the definition of "like-kind" real estate to be very broad. Examples of like-kind property include single-family rentals, multi-unit housing, commercial or industrial properties, ranches, and bare land. Provided a property has not been personally used, such as a principal residence or second home, it should qualify for a 1031 Exchange.
You must first select a Qualified Intermediary ("QI") or Exchange Company to facilitate the exchange. The QI's services must be retained prior to the closing of the existing property. Waiting until after the closing will be too late!
The QI is hired to prepare the exchange documentation and to hold the sale proceeds during the time between the sale of the existing property (Relinquished Property) and the acquisition of the new property (Replacement Property). The law requires the proceeds from the sale of the existing property be kept from your control until a suitable Replacement Property is identified and ultimately transferred to you by the QI.
Upon closing the sale of the Relinquished Property, you must adhere to two timetables which both begin on the date the existing property is transferred. First, you must identify, in writing, possible replacement properties within 45 days of the closing. The QI will provide you with a form on which you may list up to three potential replacement properties of any value.
Second, you must acquire at least one of the identified properties prior to the expiration of the 180-day replacement period. Again, this period begins on day the Relinquished Property closes. You may buy more than one of the identified properties provided if they all close within the 180-day period.
Any cash received will be subject to capital gains tax. You may take cash out at the closing of the sale property or upon completion of the exchange. Since you will be taxed on any proceeds being removed from the exchange, it will also be necessary to determine what your capital gain would be had you simply sold your property. If you take cash out equal to or more than your capital gain, then you will be paying all the tax owed. An exchange at this point would be needless. |
