When you sell real estate held for investment, you have to pay the capital gains tax. However, nobody likes to pay taxes. Luckily the so called “1031 Exchange” can offer significant savings to property owners. Wondering how you can benefit? Welcome to 1031 Exchanges 101!
A little history
If you sell your principal residence, and have lived there for two out of the past five years before it is sold, you can completely exclude up to $250,000 of any gain you have made ($500,000 if you are married and file a joint return). But if you sell investment real estate, you will have to pay the capital gains tax – unless you engage in some creative tax activities. One such procedure is described in Internal Revenue Code Section 1.1031 tax deferred exchange.
From the establishment of 1031 exchanges in The Revenue Act of 1918, the deferral of capital gains taxes was permitted under Section 1031 only for property swaps between two parties. This was the rule until the Starker family victory in 1970. When the Starker family sold its timberland in the Pacific Northwest, it put the exchange proceeds from that sale into a trust that was to be used to purchase a replacement property from another entity within five years.
The IRS fought in tax court to disallow the tax deferral in this three-party transaction, but the court ruled in favor of the Starker family. With this verdict, the court created a powerful wealth-building tool for real estate investors.
How does it work?
An investor can defer recognition of gain, by reinvesting in similar property within certain time limitations and other restrictions. You are swapping one asset for another. The philosophy of the 1031 Exchange is based upon the premise that if a property owner reinvests the sale proceeds and retired debt into a like-kind replacement property; their economic position has not changed.
To understand the powerful protection a 1031 exchange offers, consider the following example:
An investor sells his property and has a $200,000 capital gain. He incurs a tax liability of approximately $70,000 in combined taxes. Only $130,000 remains to reinvest in another property. Assuming a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $520,000 new property.
If the same investor chose to exchange, however, he would be able to reinvest the entire $200,000 of equity in the purchase of $800,000 in real estate, assuming the same down payment and loan-to-value ratios.
As the above example demonstrates, exchanges protect investors from capital gain taxes as well as facilitating significant portfolio growth and increased return on investment.
Seven Rules for the 1031 Exchange
1. Investment or productive use. The properties exchanged must be held for investment purposes or used in your trade or business. Your primary home will not qualify for a 1031 Exchange.
2. Like-kind exchange. To be “like-kind”, the replacement property must be of a similar nature or character to the relinquished property and must be held for investment purposes. Examples of like-kind exchanges include a commercial office for a duplex.
3. You can delay your exchange. Classically, an exchange involves a simple swap of one property for another between two people. But the odds of finding someone with the exact property you want who wants the exact property you have are slim. For that reason the vast majority of exchanges are delayed. In a delayed exchange, you need a middleman (or qualified intermediary) who holds the cash after you “sell” your property and uses it to “buy” the replacement property for you.
4. Two key timing rules. Within 45 days of the sale of your property you must designate replacement property in writing to the intermediary, specifying the property you want to acquire. Within 180 days of the sale, you must close on the new property.
6. Title taken in same name. The title on the replacement property should be the same as was on the relinquished property. For example, if an LLC was on the title of the relinquished property, it must be on the title of the replacement property.
6. If you receive cash, it will be taxed. You may have cash left over after the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash (known as “boot”) will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain.
7. Consider your mortgage and debt. One of the main ways people get into trouble with these transactions is failing to consider loans. You must consider mortgage loans or other debt on the property you relinquish, and any debt on the replacement property. If you don’t receive cash back but your liability goes down, that too will be treated as income to you just like cash. Suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property you receive in exchange is only $900,000. You have $100,000 of gain that is also classified as “boot,” and it will be taxed.
About Jaleesa Peluso
Jaleesa Peluso is a Real Estate Agent who specializes in the areas surrounding Laguna Beach and Dana Point. For more information about coastal Orange County Real Estate visit: www.jaleesapeluso.com. Contact: (949) 395-0960 or Jaleesa@JaleesaPeluso.com
This information is provided solely as a courtesy by Jaleesa Peluso, Coastal Orange County Realtor. It is deemed reliable, but not guaranteed. We recommend you consult with a qualified intermediary, attorney or tax adviser to find out if a 1031 Exchange is beneficial in your specific situation.