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What
is a 1031 exchange? Under
Internal Revenue Code (IRC) Section 1031, a real property owner can sell his
property and then reinvest the proceeds in ownership of like-kind property and
defer the capital gains taxes. To qualify as a like-kind exchange, property exchanges
must be done in accordance with the rules set forth in the tax code and in the
treasury regulations. The 1031 exchange can offer significant tax advantages to
real estate buyers. Often overlooked, a 1031 exchange is considered one of the
best-kept secrets in the Internal Revenue Code. Why
should you consider a 1031 exchange? - Defer
paying capital gains taxes. A properly structured exchange can provide real estate
investors with the opportunity to defer all of their capital gains taxes. By exchanging,
the investor essentially receives an interest-free, no-term loan from the government.
- Leverage.
- Upgrade
or consolidate property.
- Relocation
to a new area.
- Differences
in regional growth or income potential.
- Change
property types among residential, commercial, retail, etc.
Who
should consider a 1031 exchange? If
you have real property that will net you a gain upon sale (generally property
that has been substantially depreciated for tax purposes and/or has appreciated
in fair market value), then you are exactly the person who should consider a 1031
exchange. There
are 5 tax classes of property:
1) Property used in taxpayers trade or business.
2) Property held primarily for sale to customers.
3) Property which is
used as your principal residence.
4) Property held for investment.
5) Property
used as a vacation home. Section
1031 applies to the first and fourth categories, and potentially the fifth category.
Business use is defined as, "To hold property for productive use in trade
or business." Property retired from previous productive use in business can
be qualifying property. Investment purpose defined as real estate, even if unproductive,
held by a non-dealer for future use or increment in value is held for investment
and not primarily for sale. Investment is the passive holding of property, for
more than a temporary period, with the expectation that it will appreciate. Property
held for sale in the immediate future is not held for investment.
What
are the 1031 exchange rules? The
real property you sell and the real property you buy must both be held for productive
use in a trade or business or for investment purposes and must be like-kind. The
proceeds from the sale must go through the hands of a qualified intermediary and
not through your hands or the hands of one of your agents or else all the proceeds
will become taxable. All
the cash proceeds from the original sale must be reinvested in the replacement
property - any cash proceeds that you retain will be taxable. The
replacement property must be subject to an equal level or greater level of debt
than the relinquished property or the buyer will either have to pay taxes on the
amount of the decrease or have to put in additional cash funds to offset the lower
level of debt in the replacement property.
Like-Kind
Property In
a 1031 Like-Kind exchange you can exchange any real property for any other real
property within the United States or its possessions if said properties are held
for productive use in trade or business or for investment purposes. Examples of
1031 like-kind exchange property include apartments, commercial, condos, duplexes,
raw land and rental homes*. As used in IRC 1031(a), the words "like-kind"
mean similar in nature or character, notwithstanding differences in grade or quality.
One kind of class of property may not, under that section, be exchanged for property
of a different kind or class. Examples of qualified 1031 like-kind properties
and like-kind exchanges: - apartment
building for farm/ranch
- office
building for hotel
- raw
land for retail space
- unimproved
property for commercial property
- airplane
for airplane
Examples
of non like-kind properties include primary residences, stocks and bonds, notes,
partnership interests, developed lots held primarily for sale and property to
be resold immediately after initial purchase or completion of improvements. *
Qualification for Section 1031 exchanges depends upon the extent of personal use.
1031 Timelines
Identification
Period: Within 45 days of selling the relinquished property you must identify
suitable replacement properties. This 45 day rule is very strict and is not extended
should the 45th day fall on a Saturday, Sunday, or legal holiday. Exchange
Period: The replacement property must be received by the taxpayer within the
"exchange period," which ends within the earlier of . . . 180 days after
the date on which the taxpayer transfers the property relinquished, or . . . the
due date for the taxpayer tax return for the taxable year in which the transfer
of the relinquished property occurs. This 180-day rule is very strict and is not
extended if the 180th day should happen to fall on a Saturday, Sunday or legal
holiday. Replacement
Property Identification 3-property
rule: You may identify any 3 properties as possible replacements for your
relinquished property. More than 95% of exchanges use the 3-property rule. 200%
rule: You may identify any numbr of properties as possible replacements for
your relinquished property as long as aggregate value of those properties does
not exceed 200% of the value of your relinquished property. 95%
exemption: You may identify any number of properties as possible replacements
for your relinquished property as long as you end up purchasing at least 95% of
the aggregate value of all properties identified. For
free consultation and a list of properties, call Tracy at (310) 320-0588 ext.111. 
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