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By
Gary Gorman
I'm
constantly amazed at how many millions,
probably billions, of dollars are paid in
taxes each year by people who could avoid
all of the tax on the sale of their property
by taking a few simple steps. Section 1031
is such a beneficial part of the Internal
Revenue Code that it’s a shame most
tax and legal professionals don’t know
about it. And many of those who are aware
of it don’t really understand it.
Section 1031 is a code section—its law,
not some theory or gimmick. It allows you
to roll the gain from the sale of your “old”
investment property into the purchase of your
"new" investment property. In other
words, you defer the gain until some point
in the future when you are ready to pay the
tax. And yes, there are ways that will result
in you having to never pay the tax.
Investment property is defined as property
that you’ve held for rental income,
appreciation or business use. Typically, you
must hold both the old property and the new
property for at least a year and a day to
satisfy the holding periods. It you buy a
property, fix it up, and then set it s few
months later, you are not eligible for Section
1031. Developers are not eligible for 1031
exchanges either.
If you want to stay out of trouble with the
IRS, you need to know the six main things
they look for when they audit an exchange
(and they are particular about these requirements!):
Rule
#1 - both the old property and the new property
must be like-kind property held for investment.
Like-kind property is defined quite broadly;
therefore, you may sell one type of investment
property and buy a different kind of investment
property. For example, you can sell bare land
to buy an apartment building, sell an office
building to buy a vacation home [1031
vacation home update: May 2007] or
sell a warehouse to buy bare land. Remember,
your personal residence and property held
for resale are not considered investment
property.
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A
1031 Exchange Could Save You a Ton
of Tax! |
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appeared in... |
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September / October, 2002 |
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Both the “old” end “new”
properties must be located inside the United States,
or both of the properties need to be outside of
the US. For example, if you sell in Hartford,
CT, you can buy in Honolulu, HI. However, selling
in The Hamptons and buying in Toronto would not
qualify.
Rule
#2 - from the day you close the sale of your old
property you have 45 days to complete a list of
properties that you may want to buy. The list
needs to identify the property clearly enough
that an IRS agent could walk up to the property
based on your written description (street address
or legal description). A good rule of thumb is
that your list should include three or fewer properties.
Rule #3 - again from the day you close the sale
of your old property, you have 180 days to close
on the purchase of one or more of the properties
from your 45-day list. Both the 45 and 180 day
time frames are cast in concrete—there are
no exceptions or extensions.
Rule #4 - you can not couch the money in between
the sale of your old property and the purchase
of your new. By law, you must use an independent
third party, called a Qualified Intermediary,
to hold your proceeds. The qualified intermediary
will also prepare the legal documents required
to link together the sale of the old property
and the purchase of the new as a qualified exchange.
How do you pick a qualified intermediary? Look
for one who is bonded. There are no laws governing
intermediaries, so look for knowledge & reputation.
It’s what you don’t know that will
get you into trouble.
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Also,
be sure that they hold your money in a separate
account. Commingling your funds with other exchangers’
money adds significant risk to the security of
your funds.
Rule
#5 - you must take title to the “new”
property in exactly the same way that you hold
title to the “old” property. If you
hold the old property as Fred Jones, you cannot
buy the new property as Jones Investment Corporation.
There are some exceptions to this rule for situations
like revocable living trusts.
Entities
like corporations, partnerships, LLCs and trusts
may do 1031 exchanges. Foreign investors who own
real estate in the United States are also eligible.
If a foreign investor does a 1031 exchange, the
10% FIRPTA withholding tax is abated.
Rule #6 - in order to defer 100% or the capital
gains tax, you need to meet two requirements.
First, you need to buy a property that is equal
or higher in value than the one you sold. Second,
you need to reinvest all of the proceeds from
the sale into the new property If you purchase
a lower valued property (buy down) or if you don’t
reinvest all of the proceeds (boot), you pay tax
on the amount of the decrease and the amount of
cash taken out of the transaction. All of the
difference is subject to tax because in a 1031
exchange the gain is taxable first. Although,
the good news is that the buy down (or “boot”
as the IRS calls it) is eased at capital gains
rates.
There is no limit to how many times you can do
an exchange; you just have to hold each property
for a year and a day. So the bottom line is this,
if you plan to buy more real estate with your
proceeds, a 1031 exchange is the only way to go.
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