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1031 Exchange: Capital Gains Tax Deferral

Posted by Helena Grossberg on June 14, 2014
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1031 Exchange is a tax-deferred exchange program that the Internal Revenue Service, IRS, permits on investment property. The exchange is in reference to the selling of a property and buying of another by the same person or legal entity.

The selling of a property can incur capital gains when the asset’s selling price is higher than its original purchase price. Capital gains are subject to a 15% to 35% tax depending on the structure of the purchase of the property.  A 1031 Exchange defers the capital gains tax when the property is sold again.

Advantages of a 1031 Exchange –  The property owner may dispose of a property without incurring any immediate tax liability, increasing its purchasing power. For this reason, the new property must be similar to the original one. That is, the exchange must be in the USA, of one apartment, for example, to another residential property, of a warehouse to another commercial property and so one. These properties are called Like-Kind, and the 1031 Exchange rules allows an investor to pay the capital gains tax only when the new property is sold again, and only for the difference between the new selling and fair market value at transfer time.

Disadvantages of a 1031 Exchange  There are disadvantages that must be considered before doing an exchange. The first one is the cost of the transaction, such as closing costs and professional fees. There will also be a reduced basis for depreciation on the new property. The taxpayer may not use any of the net proceeds from the disposition of the property for anything other than reinvesting in another property to avoid tax consequences.

Qualified Intermediary  To make a 1031 Exchange, the government requires it to be handled by a Qualified Intermediary that will consider other factors as well, such as non cash proceeds (such as a boat received as a trade in), or any other payment, no matter how insignificant, so that it will not disqualify the entire transaction.  The intermediary must also be familiar with Foreign Buyers issues, such as FIRPTA, the Foreign Investment in Real Property Tax Act.

Specific Rules for 1031 Exchange:

  1. The new property must be located within the USA.
  2. From the closing date of the original property, the owner has 45 calendar days to find the new properties to buy (or identify up to three options) and provide the qualified intermediary. This is called The 45-Day List.
  3. The new closing must be within 180 of the sale and close of the original property.
  4. The titles of the properties must be in the same names.
  5. The value and price of the new property must be higher than the original property, but by no more than 200%.
  6. The proceeds from the original property must go to a qualified intermediary to complete the transaction and be used for to purchase a new like-kind property.
The counting of days is calendar days, and it includes Saturdays, Sundays, and Holidays, and it cannot be extended.

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