A common statement we hear from a number of people is “I am not even going to bother doing an exchange. I’m just going to cash out, pay my 15% and move on.” What these individuals do not realize is that they could be subject to not only capital gains tax but state tax and depreciation recapture. It’s no secret that capital gains tax will most likely increase from the current 15% to between 20-30%. This could pose a big financial burden on taxpayers who sell investment property that has a substantial gain. Add to that the potential for 25% depreciation recapture and applicable state taxes, and the end result is that the taxpayer ends up paying more in taxes than they anticipated.
During the economic downturn, the number of taxpayers utilizing a 1031 exchange was few and far between. Investors with fairly new properties had little or no gain to defer. In fact, a number of properties decreased in value. These days, it appears that things are starting to come full circle. More and more investors are utilizing the exchange again to save valuable tax dollars. Taxpayers with older properties that have significant appreciation are taking advantage of the current prices of real estate. For example, they are exchanging from vacant land to rental properties, or vice versa.
1031 is a section of the tax code which states that if you sell a piece of business use or investment real estate and purchase another piece of business use or investment real estate, you can defer not only all of capital gains, but also any applicable state and depreciation recapture taxes. This tax code is geared specifically for the investor. This means that one cannot exchange a primary or second home. The property must be held for investment or business use. The IRS has set forth specific rules to ensuring that the taxpayer has a viable 1031 exchange. Here are the main rules:
- The property involved must be held for business or investment use. All real estate is considered like-kind. In other words, vacant land can be exchanged for commercial property, etc.
- A Qualified Intermediary (QI) must be used to facilitate the entire transaction. The QI is an independent third party whose only role is to facilitate the exchange and ensure that the IRS guidelines are followed. The QI cannot be an agent or relative of the Exchanger (ie. Attorney, Realtor, CPA, etc.).
- In order to defer all of the capital gains and any other applicable taxes, the Exchanger must purchase a property that is equal to or greater than the Net Selling Price (NSP) of their relinquished property. The Net Selling Price is the contract sales price minus Realtor Commissions and title closing costs.
- The Exchanger has a total of 180 days to complete the exchange. This means that he or she must close on all intended purchases within 180 days of closing on the sale of the relinquished property.
- Within the first 45 days of that 180 day period, the Exchanger must identify up to 3 possible replacement properties for the exchange. Only what has been identified by day 45 will qualify for the exchange. No revocations or changes can be made once it is beyond the 45th day.
If the taxpayer follows these rules, they can almost guarantee a flawless exchange. An exchange can offer not only substantial tax benefits, but also provide an opportunity to diversify one’s portfolio. Every situation has its own unique characteristics, so it is very important that taxpayers consult their tax advisors before embarking on a tax-deferred exchange.
1031 Tax Free Strategies has been serving as a Qualified Intermediary for 1031 Exchanges for over 15 years. Please feel free to contact us anytime at 239.333.1031 with any questions that you may have regarding the exchange process.
Written by: Dave Owens, Managing Member of AdvantaIRA Trust, LLC.