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| | Tax Free Exchanges - 1031 Exchange
The terms tax free exchange or 1031 exchange are used interchangeably to describe a tax free exchange, actually tax-deferred exchange, of qualifying real estate under Section 1031 of the Internal Revenue Code, hence the name 1031 Exchange.
A tax free exchange of real estate is worth every person's consideration if he or she owns properties that would qualify for tax free exchange treatment under Section 1031 of the IRS Code.
You get most of the ins and outs of tax free exchanges from us here in very easy-to-understand terms. It's worth the reading. | |
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| | You do not have to be a millionaire investor or a sophisticated tax planner to take advantage of this truly great tax benefit that the Internal Revenue Service confers on property owners. If you own real estate in your business (a gas station, trade shop, convenience store, anything), or; if you own a second home; or if you own any type of investment property, you may qualify for this great tax-savings opportunity.
The point is, don’t allow yourself to be discouraged or frightened away from pursuing something that you think is too complicated or too sophisticated for you to take advantage of. You can save you tens of thousands of dollars in tax money with some very simple planning and, in the process, help yourself to accomplish many of your retirement goals. There are 1031 Exchange experts who, for a relatively small fee, will guide you in the process every step of the way. Section 1031 of the Code actually requires the use of this type of expert, one that the tax code refers to as a Qualified Intermediary. The Qualified Intermediary will handle every step for you so that all you have to do is to have property that meets the requirements of the tax free exchange rules. They do the rest. | |
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| | A 1031 Exchange is most often referred to as a tax free exchange, but in reality, it is a tax deferred exchange that permits you, within a specified time frame (not to exceed a 180 day period) to sell your own property and, within the 180 days following, acquire a new replacement property or properties. You may acquire more than one replacement property in exchange for the property that you sold to take its place in the exchange. What a tax free exchange permits you to do, in effect, is to rollover the equity you have earned in your property over time, into a new property or multiple properties without recognizing the gain in the old property that you sold.
Example: [Note that this example is greatly simplified to illustrate the basic idea behind the tax free exchange. There are other rules to consider and follow in order to qualify for a 1031 exchange, but those would be meticulously followed by the “qualified intermediary” appointed to handle your transaction. I am not a tax planner and am giving neither legal nor tax advice. This is merely an example of how a tax free exchange may work to your personal benefit. You should seek your own legal or tax advice in all circumstances.]
Tom is 59 years old and wants to begin to plan for his retirement with his wife. For the past 20 years he has operated an auto body shop from a building that he owns. He purchased the building in 1988 for $200,000 with a $50,000 cash down payment and a $150,000 loan. Over the years, Tom paid down the loan so that its current balance is $50,000. Tom’s building is presently worth $750,000.
If we apply the rules governing tax free exchanges to Tom’s situation, Tom presently has $700,000 in equity in his auto body shop building ($750,000 current value less his remaining $50,000 loan balance). Under the rules for 1031 exchanges, Tom, through a Qualifying Intermediary, would sell his building to a buyer for $750,000. In normal circumstances, Tom would be responsible for capital gains taxes on a gain of $550,000 that he realized on the sale of his building ($750,000 less his $200,000 purchase price). Depending upon Tom’s individual tax status, the tax owed could be as much as $82,000.
Instead, Tom has identified a home that he wants to purchase for his retirement. He doesn’t plan to live in the home yet and will hold it as a rental property until he decides to retire. The purchase price for the new home is $350,000 which covers only half of Tom’s of the $700,000 equity that Tom has in the auto body. Tom’s Qualified Intermediary therefore recommends a second $350,000 investment property for Tom to acquire as part of the 1031 property exchange so that Tom will have acquired 2 replacement properties totaling the $700,000 in equity that he had from his auto body shop.
As long as Tom, through the Qualifying Intermediary, acquires these two properties within 180 days of the sale of his auto body shop, Tom would pay no tax on the sale of his auto body building despite the fact that he had a sizeable gain.
In the end, thanks to the tax free exchange, Tom purchases his possible future retirement home, owns a second investment property, and has saved potentially $82,000 in taxes in the process. And, if Tom moves into the retirement home in another year or two, that home would become his primary residence and would be subject to the very favorable tax rules governing primary residences where Tom and his spouse will each be able to cover $250,000 in gains tax free provided that they make the home their primary residence for at least 2 years. | |
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| | There are several sets of 1031 exchange rules that must be followed in order for a transaction to qualify as a tax free exchange. I have tried to make it as simple as possible for you to determine whether your situation may qualify for a 1031 exchange under the rules and how to apply them. Again, 1031 exchanges require the appointment of a qualified intermediary to carry out the tax free exchange for you so that 1031 exchange expert will be your main advisor. Use the description of the tax free exchange rules, outlined below, merely as a helpful guide.
- Tax Free Exchanges (No Primary Residences) - Your primary residence will not qualify for any part of tax free exchange so if you planned to acquire a primary residence as part of an exchange, you would need to do some further planning. It is possible to do, but it requires some additional planning along with a required holding time for your 1031 exchange property following purchase. See number 12 below for guidance on required holding periods of 1031 properties.
- Tax Free Exchanges Do Not Require a Direct Swap of Properties - In a tax free exchange you are not required (and it would be extremely difficult) to arrange a direct swap of properties with another seller. You may can qualify for a tax free exchange by selling your own property to any buyer as long as you do at least two other things: 1) provide written notice of intent to the IRS that you plan to do a tax free exchange of your property and 2) within 45 days thereafter identify, in writing, the property or properties that you will acquire as part of the 1031 tax free exchange.
- In a 1031 Exchange How Much of My Tax Can I Defer? - You can defer 100% of the tax that you would have otherwise owed on the gain from the sale of your property. However, in order to defer 100% of the gain in the 1031 exchange, you must be sure to acquire a property or properties that have an equal or greater value than then net sales price of the property sold. Otherwise, you may achieve tax deferral on only a proportionate part of your tax liability rather than achieving a 100% deferral.
- Tax Free Exchanges and Qualifying Properties – In general, property that qualifies for a 1031 exchange must be real property that is either held for investment or property that was owned and used as part of a business or productive trade (like the auto body shop example above).
- 1031 Exchanges and the Qualified Intermediary – The rules of tax free exchanges require that you select and utilize a “qualified intermediary” from beginning to end of your 1031 exchange transaction. This is probably the most important thing for you to remember about the rules for 1031 exchanges. As long as you select and appoint the qualified intermediary from the very start, you will be much less likely to suffer a misstep along the way. It will make your tax free exchange go as smoothly as possible from start to finish along with giving you peace of mind in the process.
- Tax Free Exchanges and Multiple Properties - In a 1031 exchange, you may exchange your single property for multiple other properties that qualify. You are not limited to exchanging a single property for a single other property.
- Tax Free Exchanges and the 180 Day Rule – In order for your exchange of properties to qualify as tax free, you must acquire the replacement property or properties within 180 days of selling your own property. If you exceed the 180 days for any reason, your tax free exchange will be disallowed. Note that your 180 day period can be shortened by the fact that Section 1031 makes the period the lesser of 180 days or the due date for filing of your next tax return. The way to insure the 180 day period is by making sure to file an extension for the due date of your next tax return. Your qualified intermediary would be sure not to miss this point.
- 45 Days to Identify the Properties that are the Subject of the Tax Free Exchange – Once you sell your own property that you plan to exchange, you have 45 days thereafter to identify to the IRS the property or properties that you are going to purchase (within the 180 day period) to complete the 1031 exchange. Your qualified intermediary will obviously assist with this as well.
- How Many Properties Can You Identify in a 1031 Exchange? – You can identify multiple properties that you intend to acquire during the 180 day period in order to complete the 1031 exchange. However, the total value of the properties identified cannot exceed 200%, or double the value, of the property you sold. So, if the property you sold in the first part of the exchange was valued at $1,000,000, the properties that you identify to acquire cannot have a total value exceeding $2,000,000.
- New Construction as Part of a Tax Free Exchange – The property that you identify for purchase in your 1031 exchange may be new construction, property that is to be constructed, or what we generally refer to as a preconstruction property. Your Qualified Intermediary would purchase your building lot (it cannot be property you previously owned) and you will be given credit in the exchange for the value of the property for which construction is complete at the end of the 180 day period. In other words, if the construction is not completed, you receive credit in the exchange only for the value of the completed portion of the construction as of the end of the 180 exchange period. Make sure that the construction is ready to go and proceeds expeditiously.
- Second Homes Can Now Qualify for 1031 Exchange Tax Treatment – Revenue Procedure 2008-16 went into effect in March of 2008 to clarify how second homes or vacation homes may qualify as part of a tax free exchange under Section 1031. In general, as long as you do not use the second home or vacation home for the greater of 14 days per year or 10% of the number of days that it was actually rented in the 12 month period, the IRS will treat your second home as an “investment” property for purposes of qualifying under a 1031 tax free exchange. According to this new guideline, if your second home is rented for 200 days of the year, for example, you may use it for 20 days out of the year and it will still qualify for the tax free exchange.
- How Long Must You Hold a Property in Order to Maintain Its Tax Deferred Status Under the Rules for a 1031 Tax Free Exchange? – There are no defined rules for the holding period of a property that was part of a tax free exchange. That being said, the general guidance is that to preserve the tax free status in the exchange you should hold the property as investment property for no less than one year (and many advisors would caution that you make the minimum holding period at least 2 years). You should consult your qualified intermediary or tax advisor on this one, but the one year holding period seems to be a fairly safe bet considering that Congress actually considered making this the rule in legislation that was considered back in 1984. In addition, it is consistent with a one year holding period for capital gains tax treatment on other investment property and a one year holding period is no less arbitrary than a 2 year holding period.
- Tax Free Exchanges and the Like-Kind Property Requirement – Section 1031 requires that properties be like-kind in order for the exchange to qualify as tax free. On this subject, here is a tax tip taken directly from a recent IRS Publication. “Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.” In general, as long as you are exchanging real estate for real estate and the property is within the U.S., you have a high likelihood of meeting the IRS definition of a like-kind exchange.
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| | In a tax-free exchange of real estate, the property that qualifies as 1031 exchange real estate is such an important part of the transaction that it deserves a little further discussion. As noted immediately above, in order to qualify for a 1031 exchange the property being exchanged must be “like-kind” according to the IRS definition. For this purpose, like-kind is very broadly interpreted to mean real estate, whether improved or unimproved. The only limiting factor on this is that the property being exchanged must be in the United States. Foreign properties will not qualify for a like-kind exchange. And, of course, the property must always be seen as being for investment or business purposes.
An important factor in what qualifies as investment property for purposes of IRS treatment as 1031 exchange real estate is intent. The IRS and the courts will look into the parties’ intent with respect to a property being considered investment property under a Section 1031 exchange. In some cases, the courts have upheld property as being an investment property even though the holding period following the 1031 exchange was as short as 6 days. And, in other cases, the courts have disallowed the “investment” characterization despite the fact that the property was held for 6 years. What is clear is that classification as 1031 exchange real estate will be determined on a case-by-case basis with the intent of the party being one of the most important factors. | |
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| | Have you owned a vacant piece of land for speculation and now want to sell it? This vacant land would likely qualify as a 1031 exchange property even though you may choose to exchange it for one of our preconstruction homes.
You can also exchange your duplex or four-plex for a single family home, provided that the new single family home is not your primary residence.
You can exchange the building that you owned to house your business in all of these years (your business property) for residential property.
Or, perhaps you have held a piece of land on which you had planned to build a second home or retirement home, but now you have changed your mind about building there. You could exchange that for a new piece of vacant land somewhere else with a home to be built on it.
The point is that, aside from excluding personal residences from the category of 1031 exchange properties, nearly any other real estate that arguably has a business or investment intent will qualify, even if that property does not yet fully exist. Consult with a 1031 exchange expert or qualified intermediary for their advice on your specific needs. | |
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| | A Great Retirement, Investment and Tax Savings Strategy Surely, sometime in your life you have heard the expression “that’s killing two birds with one stone.” But, have you ever heard of possibly killing 3 birds with one stone. (By the way, it’s just an expression. We would never even think of killing a single bird with a stone or otherwise. You can’t be careful enough with what you say these days.)
If you are a retiree or near term retiree considering a new home in a great place to live, we may have a strategy that will jumpstart your retirement with multiple tens of thousands of dollars in savings. It makes a great retirement, investment and tax savings strategy – think of retirement, investment and tax savings as the three birds I was referring to above.
If you presently own a rental property, a building that is part of your business, or even vacant land there is a 1031 exchange plan that can benefit you greatly. Here’s how it can work for you.
You sell your current business, rental or investment property with the idea of rolling over its equity into a new property (a preconstruction home in one of our resort style active adult communities or perhaps even one of our finished homes) as part of a 1031 exchange. To qualify for the 1031 exchange, your intent would be to purchase one of our homes as an investment property. You could do this either as a rental property or as a model home that we would lease back from you at a guaranteed rental for at least one year. By establishing your intent to make this home a rental property, it qualifies as 1031 exchange real estate.
At some future point, at least one year later, and also provided that you like the home and community enough to make it your personal residence, you move into the home as your primary residence. Following is an example of how you would likely save.
1031 Exchange Example:
You sell a business or investment property that you own for $380,000 and, through a qualified intermediary as part of a 1031 tax free exchange identify one of our homes as the replacement property or property to be acquired in the exchange. Your tax basis in this property is $130,000 so your deferred taxable gain would be $250,000 (the $380,000 sales price less your $130,000 basis in the property).
We sell you one of our homes for $340,000 and help your qualified intermediary to acquire a building lot for you in the community of your choice. The lot cost is $40,000. In this case, just for simplicity in the example, the home and lot cost total of $380,000 is exactly equal to the sale price of the property that you sold to begin the 1031 exchange.
The home that you purchased from us at $340,000 has an actual market value of $420,000 so that, together with the $40,000 building lot, the total property would be valued at approximately $460,000. You start this new home investment, based on our discount home-building program, with $80,000 in built in equity (less any closing costs or interest carrying costs that you may incur).
At this point in the transaction, you have $250,000 in unrealized gain that was carried over from your original property, plus the $80,000 in built-in equity that you picked up by virtue of your wholesale purchase of one of our homes.
You rent this home for a period of at least one year or even as long as 2 years as an investment property and later decide that it is a home and community that you, yourself want to live in. So you move into the home as your primary residence.
Three years later, you decide that you want to move to another location and you sell the home which has been your primary residence for the past 3 years. In that time, its value has appreciated by 4% per year due to the fact that it has been in a stable market where the demand for quality retirement living has helped to keep home prices on a steady climb. In that span of 5 years, your original $460,000 home is now worth $560,000.
Provided that our federal tax laws do not change appreciably in the meantime, here is the likely profit and tax outcome for you on this home. You had a deferred taxable gain of $250,000 in your original property thanks to the original 1031 exchange, plus the $80,000 equity that you gained by purchasing the home from us at a well below market price, plus the appreciation of $100,000 that you enjoyed in the 5 years that you owned the home. Your total gain is $430,000 on which you would likely pay no taxes due to the fact that a husband and wife may each exclude $250,000 in gain on the sale of their primary residence. Since your gain is $430,000, but together you have exclusions totaling $500,000, you would pay no taxes on the $430,000 in the end. Not a bad way to add to the retirement nest egg.
This result is just an example and your own circumstances will surely differ, but it does serve to illustrate how you can build equity and protect your growing wealth well into your retirement years with just a little bit of planning. | |
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