Buying a home today is about more than just finding an excellent location and a beautiful house. Buyers must think about the future value of the home and its importance. Personal benefit relates to the intention of the buyer. Is this the permanent family home? A temporary property? A fixer-upper or a chance to try out those flipping skills? Most people who consider a 1031 tax abatement have a short-term interest in the property.
A 1031 tax exchange, also known as a Like-Kind exchange, allows buyers to avoid paying taxes during the process of selling and buying investment property. It is meant to assist property investors in purchasing the higher-priced property after a sale. As a concrete example, imagine an investor purchasing a piece of property for $300,000. A year later, he sells the property for $400,000 and then buys another property with that $400,000. Under normal circumstances, the investor would have to pay taxes on the capital gain (the $100,000 profit), leaving little money to buy a better piece of property.
Under a 1031 exchange, however, he can defer paying taxes on the gain until a later time and use the entire $100,000 profit to invest in a bigger or better piece of property. The concept of a 1031 exchange is the trading of properties (one bought, one sold) without reporting whether there was a loss or gain on the transaction. In essence, this exchange allows buyers to borrow the amount of the gain from the government as an interest-free loan.
1031 Exchange: Timelines and Restrictions
With 1031, there is a firm timeline that must be followed between the time that a property is sold and another exchanged. This timeline is divided into two distinct periods, the Identification Period and the Exchange Period. The Identification Period is the first 45 days of the exchange; in this time, the property to be exchanged has to be officially recognized. As such, taxpayers who have multiple properties and identify the wrong property for trade must stick with their choice. Also, if Mother Nature steps in and destroys the home that was to be exchanged, 1031 will have to be dismissed. The process of exchange is very stringent.
The exchange period ends when a replacement property has been successfully exchanged with the original property, not to exceed 180 days from the start of the Identification Period.
The principles of the 1031 tax exchange have simplified since it was initially introduced. Instead of requiring that buyers sell their current property before buying a new one, the IRS has recently allowed taxpayers to complete a reverse exchange, where the buyer purchases a replacement property before selling the original property. A non-simultaneous exchange of property is known as a Starker Tax-deferred exchange. Another simplification to the process involves the definition of “real” property.
Law states that you may only exchange real property with real property. But real property includes both commercial and residential property, as well as land. This means that under certain circumstances, taxpayers may exchange residential property for commercial property. An exception is that property inside of the United States cannot be transferred to property outside of the country. Also, the proceeds of a home sale must be reinvested within 180 days.
Following Through With a 1031 Tax Exchange
The hardest part of following through with a 1031 exchange is finding a replacement property within the 45 days given by the IRS after relinquishing the original property. However, some guidelines can increase a person’s options. First, a taxpayer may choose up to three replacement properties, of any value, from which he/she must acquire at least one of those before the 180-day deadline. Another option, called the 95% rule, allows taxpayers to choose any number of replacement properties as long as the Fair Market Value of the properties received by the end of the exchange period is 95% or more of the total FMV of all potential properties identified. Finally, the 200% rule permits taxpayers to choose any number of replacement properties as long as the total FMV of the replacement properties doesn’t surpass 200% of the fair market value of the exchanged property/properties.
Think of 1031 as a traditional IRA or 401k. When you sell assets in a tax-deferred retirement plan, the capital gains are deferred until you cash out of the retirement plan. Same with 1031. As long as you re-invest your money in real estate, you may stall on the taxes.
The step-by-step process below to benefit from a 1031 Exchange:
- Seek advice from a tax counselor CPA to ensure that you’re doing what is most beneficial for your business.
- Sell your original property, making sure to include a cooperation clause in the sales agreement which states that the buyer is aware that you intend to complete a 1031 exchange, and wants to cooperate with you to accomplish this at no charge. Please note that the closing agent is responsible in this case for contacting a Qualified Intermediary to order documents.
- Enter into a 1031 agreement with a Qualified Intermediary (who will be named as principal in the sale of your sold property and the resulting purchase of new property). The exchange agreement must meet IRS requirements regarding proceeds. Along with the transaction, an amendment to escrow is signed which names the QI as the seller. Replacement property does not need to be identified yet.
- Keep in contact with the Qualified Intermediary. The proceeds from the sale go to the Qualified Intermediary. The funds will be placed in a separate market account. It is at this point that the exchange timeline begins. Written notification of a replacement property must be sent within 45 days of this date.
- Send written identification of the replacement property before the 45th day to the Qualified Intermediary, the seller of the replacement property or an attorney. Everyone who signed the exchange agreement must sign this written announcement.
- Agree to purchase a replacement property, again including a cooperation clause. This document will show the QI as the buyer, although the deed will reflect the actual buyer.
- Wait. The Qualified Intermediary will put the exchange funds and growth proceeds into escrow. He or she will send you information regarding incoming monies.
- File form 8824 with the IRS when taxes are filed, in addition to required state tax documents.
- As a seasoned Buyer’s broker, Elika Real Estate can assist customers in finding properties that capitalize on the 1031 exchange. Also, we can help you find a Qualified Intermediary to serve as a safe harbor, as well as assist in filling out the necessary paperwork to make the deferment official.