Capital Gains Tax on Property is spelled out in Section 1031 of the Internal Revenue Code and provides for the tax deferred exchange of real and personal property.
Why Do a 1031 Exchange?
Investors can trade up, consolidate, diversify, leverage or relocate their investments and not be penalized by having to pay either capital gains or recapture (the amount deducted while owning the property is taxable if the property is sold). The taxes are deferred until the investor does a non 1031 exchange sale or dies.
1031 exchanges can be both a powerful wealth building tool and a way of adjusting investment portfolios to more accurately reflect life style choices and circumstances. An example would be an apartment owner wanting to trade into net lease properties that do not require management.
What are the general guidelines for a 1031 Exchange?
- The value of the replacement property must be equal to or greater than the value of the relinquished property less any selling expense.
- The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
- The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
- All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.
- Constructive receipt of sales proceeds is prohibited during the exchange process.
- Deadlines for identifying and closing on the replacement property must be followed.
What is Boot?
Boot is any property received by the taxpayer in the exchange which is not like-kind to the relinquished property. Boot is characterized as either "cash" boot or "mortgage" boot. Realized Gain is recognized to the extent of net boot received.
What is Like Kind?
Real or personal property of the same nature or quality is like kind. Generally, real property is like kind to all other real property as long as it is held for investment or productive use in a trade or business. Foreign real property can be trade for foreign real property while US properties can only be exchanged for US properties. Personal Property must be either the same General Asset Class or Product Class.
What are the 45 and 180 Day Deadlines?
The clock starts with the close of the property being sold. From the close date there are 45 days to identify the properties to be purchased and 180 days to complete the purchase (or the due date for your tax return-whichever is earlier). Both periods are calendar days. If the 45th or 189th day falls on a weekend or holiday, the deadlines still apply. There are no extensions for legal holidays or Saturday or Sunday.
What Constitutes Proper Identification of Replacement Property?
Property is properly identified only if you clearly describe it in a written document signed by you and hand delivered, mailed, faxed to the person obligated to transfer the replacement property to you (typical a Qualified Intermediary (QI) or to any other person "involved in the exchange" other than you or any one disqualified under Treasury Regulation 1.1031 (k)-1(K). An unambiguous description would be if it described the property using the legal description, street address or distinguishable name. If more properties than are permitted are identified it will be treated as if no replacement property was identified and the exchange will be disallowed.
To Defer Taxes How Much Must be Invested?
The minimum amount to be invested must be equal to or greater than the sales price on the property being sold less any selling expenses. If there is debt on the property being sold that amount needs to be replaced by new debt or cash from the investor's pocket.
How Many Properties May Be Identified
as Replacement Properties?
- Three Property Rule: Any three properties of any value.
- 200% Rule: Any number of properties not to exceed 200% of the sold property.
- 95% Rule: Any number of properties of any value. 95% of identified properties must be closed in 180 days or the exchange will be disallowed.
Can Multiple Owners of a Single Property Exchange
into Different Properties?
If the intent of varies owners of a single properties is to go their separate way it is important to first review with legal counsel the manner in which the property title is held before selling. Once any title issues are resolved the property can be sold and exchanged. In such a circumstance one investor can do an exchange while another can receive cash and pays taxes. It is very important that the investors be clear on their intentions before entering into an exchange agreement with a Qualified Intermediary (QI). Once the property being sold is closed and all exchange investors have entered into one exchange agreement the exchangers lose their options to divide the proceeds and buy separate replacement properties.
Does the Investor have Access to the Sale Proceeds
During the Exchange?
Part of doing an exchange is that the investor does not take constructive receipt of the sales proceeds. If no property is identified during the 45 day identification period the investor can receive their money on the expiration of the identification period. If the investors identifies properties during the 45 day identification period then does not close on an identified property the investor will have to wait the full 180 day waiting period to receive their money. There are a few limited exceptions to this rule.
Is a Delayed Exchange the Only Way to do a 1031 Exchange?
There are five ways to accomplish a 1031 exchange. They are a Delayed Exchange, Reverse Exchange, Simultaneous Exchange, Improvement Exchange and a Personal Property Exchange.
How Should the Replacement Property Be Vested?
The investor needs to hold title in the replacement property exactly as they held title to the property they sold. What this means is that the person or entity beginning the exchange needs to be the same person or entity ending the exchange. An exception would be a husband and wife (or individual) holding a revocable living trust which is a true pass through can sell then take title to the new property as individual(s). Other exceptions would be a single member LLC sells and the sole member buys as an individual or if an individual dies after selling his or her estate can purchase the replacement property.
Can an Investor Use a Personal Bank Account
To Hold Sales Proceeds?
No. The IRS regulations are very clear. The taxpayer may not receive the proceeds or take constructive receipt of the funds in any way, without disqualifying the exchange.
Is it too late to start a tax-deferred exchange after signing
the sales contract before closing?
No, as long as title has not been transferred. Once the sale is closed it is too late to do a 1031 exchange even if the proceeds check has not yet been cashed.
What is a "multi-asset" exchange?
A multi-asset exchange involves both real and personal property. For example the sale of a hotel frequently involves both real estate and furnishings and equipment. In this example an exchange would be done for the land and building and another exchange for the furnishing and equipment in a separate exchange. The definition of like-kind for personal property and equipment is much narrower than for real estate.
What is the difference between "realized" gain and
Realized gain is the increase in the taxpayer's economic position as a result of the exchange. In a sale, tax is paid on the realized gain. Recognized gain is the taxable gain. Recognized gain is the lesser of realized gain or the net boot received.