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
Shop 'til you swap
How tax code section 1031, for real estate exchange works:
Create a contract to relinquish property
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
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
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
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:
The need or desire to consolidate or diversify
The need or desire to acquire a property with
greater potential for appreciation.
The need or desire to increase cash flow.
The need or desire to relocate a business
The need or desire to transfer into (or out of) a
high basis (or low basis) property.
The need or desire to eliminate management
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
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:
Up to three properties, without regard to their fair
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"
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.
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