Ins and outs of tax-deferred exchanges of real estate

By
Services for Real Estate Pros with Representative

In the business of buying and selling homes just about anything can happen.  You can have surprises during renovation or you can deal with unexpected expenses. However, these impediments don’t stop people from trying. Numerous individuals invest in property, buying low and selling high. Why do they do it? Because they want to make a profit. It seems that house flipping has become a trend.

The problem with house flipping is that it’s risky. You’re better off buying investment property. You can sell it later on and make good money. When it comes to selling property at a profit, consider 1031 exchange investments. Commonly referred to as tax-deferred exchanges, 1031 exchanges allow real estate investors to postpone paying tax on gain as long as they reinvest in similar property. Keep on reading to find out more about the tax-deferred exchanges of real estate.

 

What is really meant by tax-deferred exchange?  

Anyone who sells property is required to capital gains tax. If the selling price is higher than the original purchasing price, then you owe capital gains tax. Throughout the years that you’ve owned the equity, you’ve depreciated it almost completely. In other words, you’ve obtained tax benefits from the Internal Revenue Service, benefits that made it possible for you to reduce your federal income taxes. When you sell the asset, the Internal Revenue Service will want to get back that money at a rate as high as 25%.

As mentioned earlier, you can defer your capital gains tax. All you have to do is to complete a 1031 exchange. Owing to Section 1031 of the United States Internal Revenue Code, you are allowed to sell a property, reinvest the proceeds in a new estate, and defer tax liability. Instead of selling the property, you just exchange it for a similar one. In this transaction, you sell the current asset and purchase a replacement whose value equals or exceeds the sale price of the property sold. The IRS approves tax-deferred exchanges.   

The fact is that 1031 exchanges have been realized ever since 1984. In response to the Starker decision, the United States Congress added Section 1031, demanding that a swap of relinquished property for replacement property be finalized within 180 days. In the case of Starker vs. US, both parties agreed that the buyer would purchase Starker’s estate, yet would allow him up to 5 years to find a replacement property. The decision proved to be historically important.

Tax-deferred exchanges aren’t for personal use

Attention needs to be paid to the fact that the exception is solely for investment and business property. What does this mean? It simply means that you can’t swipe your primary place of residence for another home. The tax code provides benefits to tax payers who own property held for investment or to be used in a trade of business. You can exchange real property, such as vacant land, farm land, residential rentals, and commercial real estate. But never personal property. Things are expected to change in the future. To be more precise, everything that isn’t real estate will be eligible for 1031 exchanges. For the time being, though, you are prohibited from swapping primary residences. If you wish, you can exchange vacation homes.

 

Understanding like-kind property

Over the years, there has been a great deal of uncertainty regarding the completion of the exchange. This is why, in 1991, the Treasury Department issued regulations to address many of the questions. Most of these regulations dealt with 1031 properties. The Internal Revenue Service refers to 1031 properties as like-kind. In some respects, establishing what is like-kind is difficult. For 2 assets to be like-kind, they have to be part of the same general business asset class.          

The designation like-kind refers to the nature of the property and not its grade or quality. Practically, the 2 assets exchanged have to be of the same type. For instance, you can swap a residential rental house for vacation land. Let’s take another example. You can sell a piece of land and acquire an apartment building. As long as you follow the rules imposed by the IRS, you can build and preserve the wealth, generating money from the investment and consolidating real estate holdings.  

What are the time limits of a tax-deferred exchange?

You have exactly 45 days from the date that you sell the relinquished real estate property to identify a suitable replacement. In the written identification, you must provide full details, such as legal description, street address, and name. If you were paying attention, then you already know that you have 180 days to close the deal.

What happens if the relinquished property is transferred near to April 15? In this case, you need to file an extension to the tax return. There is an exception to the rule. It’s called the 200% rule and it says that the sum of all the purchase prices for 4 or more replacement properties can’t exceed 200%. If the value of the properties combined is lower than that, you’re safe.

Retaining the services of a qualified intermediary

A tax-deferred exchange shouldn’t be confused with a do-it-yourself project. It’s a serious thing and it should be handled by a professional – in other words, a qualified intermediary. The qualified intermediary can be an attorney, accountant, investment banker or broker. The qualified intermediary facilitates the 1031 exchange, acting on behalf of the buyer and the seller. The facilitator is the one who is held responsible for the real estate property and tax obligations.

Qualified intermediaries aren’t overseen by federal governments. They are trusted to do their job, which implies complying with the law and treating investors fairly.  It’s not recommendable to wait until the last minute to seek help. You’re prone to making mistakes and those mistakes can affect the transaction. Find someone that has years of experience in 1031 exchanges. The last thing that you want is errors and omissions. Most importantly, make sure that the facilitator has qualified staff members. If they don’t know what they are doing, then things won’t go according to plan. 

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Rainmaker
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Norma J. Elkins
Elite Realty Group - Morristown, TN
Realtor - Elkins Home Selling Team

Great blog...thanks for sharing!

May 16, 2018 05:09 AM #1
Rainmaker
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James Grant
Asheville, NC

Hello, Cynthia, Great Information. Thanks for sharing!

May 16, 2018 07:15 AM #2
Rainmaker
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Cynthia Madison
Representative - Alachua, FL

Thank you very much! I am glad you like it!

May 18, 2018 02:13 AM #3
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Cynthia Madison

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