Tax Deferred Exchanges

Tax Deferrals Under Internal Revenue Code Section 1031

TAX DEFERRED EXCHANGING is an investment strategy that should be considered by anyone who owns investment real estate. A tax deferred exchange is simply a method by which a property owner trades one property for another without having to pay any federal income taxes on the transaction.
Shop 'til you swap
How tax code section 1031, for real estate exchange works:
Create a contract to relinquish property Documentation needed:
Agreement with qualified intermediary

Funds to escrow account
Sale of property and settlement
Create a contract on replacement property 45 days to name new property
Within 180 days
Settlement for replacement properties
Report exchange on IRS Form 8824
An investor using Internal Revenue Code Section 1031 IRC 1031) can exchange vacant land for a rental home, a duplex for a fourplex, an apartment complex for a shopping center or rental houses for an office building. The use of the property is the factor determining the tax treatment. A traditional exchange requires two parties who want each other's properties. While possible, two party exchanges are rare. A tax deferred exchange usually involves four principal parties: the exchanger (the taxpayer), a buyer for the relinquished property, a seller of the replacement property, and the intermediary. The parties often do not know each other, and their properties may even be located in different states.

The transaction involving the relinquished property does not have to close at the same time as the closing on the replacement property. The exchanger is allowed up to 180 days after the closing on the relinquished property to close on the replacement property.

To write a purchase contract in Colorado, print out this state approved Exchange Addendum to Contract to Buy and Sell Real Estate and use along with the Colorado Real Estate Commission (CREC) approved contract form. Please consult your local realtor or attorney for additional information. Always use a qualified intermediary to ensure proper tax procedures.

The primary advantage of a tax deferred exchange is that the taxpayer may dispose of property without incurring any immediate tax liability. This allows the taxpayer to keep the earning power of the deferred tax dollars working in another investment. In effect, this money (the taxes deferred), can be considered an interest free loan from the IRS. This tax liability is forgiven upon the demise of the taxpayer, which means that the taxpayer's estate never has to repay the "loan." The heirs get a stepped up basis on such inherited property. That is, their basis is the fair market value of the inherited property at the time of the taxpayer's demise.

Some reasons for considering a tax deferred exchange:

Some Requirements Regarding IRC Code § 1031 Exchanges

Use of Properties: Both the old and new properties must be held for productive use in a trade or business, or for investment, and cannot be for personal use.

Relinquishment of Properties: The relinquished property must be exchanged. The IRS regards exchanges coordinated through a Qualified Intermediary as a "safe harbor."

Acquisition of Replacement Property: The replacement property must be acquired through an exchange.

Replacement Period: After the disposition of the relinquished property, the replacement property must be identified within 45 days, and the purchase completed within 180 days.

Exchangors: Exchangors are related parties, the holding period is two years. Otherwise, the Service looks back to the investor's intent. The Exchanger must be able to show a bona fide intent to enter into a deferred exchange at the beginning of the exchange period.

Cash Reinvestment: In order to be completely deferred, an Exchanger must roll all the equity and undertake the same or greater debt in the replacement property. Complete deferral and reduction of debt on the new property can be achieved if the Investor adds additional cash for the acquisition of the replacement property.

Alternative & Multiple Properties: Whether one property or more than one property is transferred by the taxpayer as part of one exchange, the number of replacement properties that may be acquired is:

  1. Up to three properties, without regard to their fair market value.
  2. More than three properties, if the total fair market value (the fair market value at the end of the 45 day identification period) of all these properties does not exceed 200% of the total fair market value of all properties relinquished in the exchange.

Do you have single family rental property purchased years ago with big gains? It may not be convenient, but if you and your spouse move in and live there for 2 years, then you can sell and avoid tax on the first $500,000 of gain ($250,000 for a single taxpayer). In fact, you could unload a whole portfolio of rental houses and possibly do so tax free by living in each for 2 years before selling

Along the same line, you might consider selling your personal residence to take the equity tax free and purchase a replacement home using new financing. The money from the sale is again non taxable and can be used for other investments.

In May 2003, Congress passed the Job & Growth Tax Relief Reconciliation Act. This new tax revision lowers long-term capital gains taxation from 20 percent to 15 percent. For example, if you have $200,000 profit in property you have owned for over one year, the new tax liability if $30,000 versus $40,000 from the old tax code. A 1031 Tax Deferred Exchange is still an alternative to paying current taxes.

The Oct. 22, 2004 tax revision now requires any 1031 Exchange to be held a minimum of five years before converting to a principal residence. Sale of the relinquished property must close first, followed by the purchase of the replacement property to qualify for the "Section 1031" tax deferment.

Note: this information is presented to answer commonly asked questions regarding tax deferred exchanges. This information should be reviewed by independent legal and tax counsel.

Thank you for considering our services. Let me help you find the perfect investment.