1031 Tax Exchanges

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The Tyson Group is ready to help you with your next 1031 tax exchange. We specialize in putting buyers and sellers together for 1031 exchanges and have a combined 40 years experience in selling commercial and residential real estate in New Bern and Eastern N.C.

The following information is presented to give you a general idea about the IRS 1031 program. Any specifics regarding 1031 should be discussed with a CPA or a tax attorney.

The 1031 Tax Exchange

One of the reasons that real estate is such an attractive investment is that you do not pay Social Security or Medicare taxes on unearned( rental or capital gain ) Income. Another reason real estate can be attractive to investors is because the IRS 1031 exchange program allows you to defer paying taxes on capital gains which occur when you sell real estate for a profit. Trading or exchanging property has gone on for many years but there were no clear IRS rules on how those transactions would be taxed. That all changed in the summer of 1990 when the I.R.S. finally came out with the long awaited rules on Deferred Exchanges.

Section 1.1031 of the Internal Revenue Code laid out in detail the procedure for turning a sale and purchase type transaction into an exchange. Please note that private residences do not qualify under this program. The 1031 program pertains to property held for investment (raw land), to produce income, or used in a trade or business.

It is important to understand that I am a real estate broker and not a licensed CPA or attorney. Please consult with those professionals to verify the tax and legal information contained in this webpage. My goal is simply  to make individuals aware of an IRS program that could potentially defer taxes on the capital gain that is realized from the sale of investment property.

Why would someone want to exchange property instead of just outright selling the property? There are many reasons, listed below are a few:

1. To defer paying capital gains on the sale of a property.

2. To exchange for an investment property located closer to your new home or in a different area.

3. To move from one type of investment property into another. An example would be moving from residential investment property to commercial investment property.

4. To exchange fully depreciated property for non-depreciated property to take advantage of the tax break on depreciation.

5. To exchange older for newer rental property to reduce maintenance expenses.

Although the 1031 program is often referred to as a tax-free exchange, it is actually a tax-deferred exchange. Uncle Sam is not going to let you off the hook entirely. However, at present he is willing to let you postpone the tax obligation indefinitely. Before we delve into the 1031 program, the following are a few terms of which you should be fully aware in order to understand the program.

Income tax

A taxpayer is required to pay taxes on both earned income and unearned income.

Earned income is the salary or commission you earn from your employer.

Unearned income can be one of four kinds. They are the following:

1.Interest income

2.Dividend income

3. Rental income

4. Capital gain income

What is a capital gain?

If you purchase, inherit, or receive as a gift an asset and sell the asset, you will probably incur a capital gain or a capital loss. A capital gain will be taxable. If instead of a reaping a profit you incur a loss, the capital loss is tax deductible. An exception to this is the case when someone inherits property. In that case, the first $1 million is exempt from capital gain, should the heirs sell the property.

There are two kinds of capital gains.

1. Long-term Capital Gain occurs when an asset is held for one year or longer. Currently the rate for long-term capital gain is 15% for most tax brackets, which is much lower than ordinary income tax for most taxpayers.

2. Short-term Capital Gain occurs when an asset is held for less than one year. Short-term capital gains are taxed at ordinary income rates.

The 1031 Tax Free Exchange

Section 1031 of the Internal Revenue Code states:

No gain or loss shall be recognized  on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind, which is to be held for productive use in trade or business or for investment.

Investment property could include apartments, raw land, rental homes, or office space.

Property used for productive use could include machinery, business equipment, etc.

Please note that private residences do not qualify under this program.

Types of 1031 Exchanges

1. The simultaneous exchange: This occurs when you sell and purchase properties at the same time.

2. The delayed exchange:  This occurs when you sell a property and delay (up to 180 days) purchasing another property.

3. Reverse 1031: This occurs when you buy a property and later sell your already identified exchange property.

The Identification Rule

The relinquished property must be exchanged for other property, rather than sold for cash and using the proceeds to buy the replacement property. Most deferred exchanges are facilitated by qualified intermediaries, who assist the taxpayer in meeting the requirements of section 1031.

Prior to closing on the property you own, you must demonstrate your intent to pursue an exchange. This is done with a form that must be completed and turned over to your 1031 trustee.

Starting on the day the property or properties you intend to exchange are sold (closed), the proceeds of the sale must go directly to and be held by a 1031 trustee. If you take possession of the funds, you lose the opportunity for an exchange. Within 45 days from the closing date on the sold property, you must identify at least one potential replacement property. Failure to identify a new property or properties within 45 days will result in losing the tax deferment on the sold property.

If you are not sure what property or properties you want to buy within the 45 days, you can identify more than one property and figure it out later. How many properties can you identify? There are several rules that determine how many properties you can identify. These rules are beyond the scope of this webpage and you should consult with your CPA or attorney to determine the best avenue for you to take.

You will have a total of 180 days to close on the property or properties you have identified. The 180 days includes the 45 days you were given to identify a property.

Below are listed a few general guidelines to follow in order to defer all of the taxable gain on your exchange.

  1. Make sure that the value of the replacement property is equal to or greater than the value of the relinquished property.

  2. The equity in the replacement property must be equal to or greater than the equity in the relinquished property.

  3. The debt on the replacement property must be equal to or greater than the debt on the relinquished property.

  4. All of the net proceeds from the sale of the property must be used to acquire the replacement property.

Investing in real estate can yield high returns if you pick the right properties.  Always consult with an experienced realtor to make sure you are getting the most bang for your buck. And check with your CPA or attorney for information on 1031 tax exchanges. I hope you have enjoyed this article. Please send me your comments.

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