A Tax Haven For Preserving Real Estate Wealth
The 1031 tax
deferred treatment of capital gains is one of the best real estate
investor vehicles for preserving and building real estate wealth: This
provision of the Internal Revenue Code allows property owners to
exchange their property for other like-kind property without recognition
of capital gains. It makes possible to transfer the financial gain that
is realized from the sale of a property into another property without
federal capital gains tax at the time of the sale.
New Tax Terms:
A deferred exchange is an exchange in which you transfer qualified
property called the "Relinquished Property" and subsequently receive
qualified property as consideration. The property received is called
"Replacement Property".
The Deferred
Exchange Regulation is a taxpayer’s dream come true. It works without
the buyer of the "Relinquished Property" or the seller of the
"Replacement Property" getting involved in your exchange. The
Regulations secret weapon was the creating of a legal entity called the
Qualified Intermediary or QI. This new entity is permitted to
serve as your agent and do all the exchange stuff for you without
getting you involved in a taxable sale of your old property. By using a
Qualified Intermediary to handle your exchange transaction, you can now
turn the sale of your property, and subsequent purchase of another
"like-kind" property, into a 1031 exchange.
This regulation
explaining how to put together the 1031 deferred real estate exchange is
a powerful tool and strategy for selling appreciated business, farms,
land, and investment real estate without recognition of gain for income
tax purposes. It spells everything out—step by step. Just follow the
rules and you can sell your appreciated property, use the cash proceeds
to buy your Replacement Property and qualify for the full benefits of
non-recognition of gain under 1031. The regulation has the weight of law
and all parties must follow it—even the IRS.
One of the
outstanding features of the deferred exchange regulation is it
establishes and defines the Qualified Intermediary (QI) as your vehicle
to qualify for the safe harbor procedures you must follow to get
non-recognition of gain treatment on your deferred exchange.
Exchange Requirements for Non Recognition of Gain
There are three
conditions that must be met to accomplish non-recognition of gain under
IRS Regulation 1031:
1. The properties
exchanged must qualify, and be of "like-kind".
2. There must be an
actual exchange, not a transfer of property for money only.
3. The time
requirements must be strictly followed.
Qualified Properties
To meet the
requirements of 1031, both Relinquished Property and Replacement
Property must qualify. In other words, both the property you are selling
and the property you are buying must be qualified property of like-kind.
If not, your exchange will fail and be classified as a sale. This is so
important it needs repeating:
To qualify as a
like-kind exchange, the property must be both (1) qualifying property
and (2) like-kind property.
For income tax
purposes, real estate is divided into four classifications.
Classification is made as of the date the transaction is made. The
classifications are:
1. Held for
business use (1231)
2. Land held
for investment (1221)
3. Held for
personal use
4. Held
primarily for sale (dealer property)
The first two
classifications—held for business and held for investment—qualify for
1031 treatment. The second two—held for personal use and dealer
property—do not.
Real Estate Held for
Investment
Real estate used in
a trade or business is not held for investment. Real estate held for
personal use is not held for investment.
Investment real
estate is a capital asset (IRC 1221). It's property held primarily for
appreciation of value due to location, passage of time and other factors
outside the activities of the owner. It is treated as a portfolio
investment asset. An example of investment real estate is raw land held
for appreciation. Even if purchased with the idea you might someday
develop the property, if you don't develop it (for any reason), the
property will not lose its classification as investment property. Real
estate used in a trade or business is not held for investment. Real
estate held for personal use is not held for investment.
If sold at a gain,
the gain is a capital gain. If sold at a loss, the loss is a capital
loss subject to the capital loss limitation rules.
Real estate held
for investment qualifies for 1031 treatment when exchanged for other
investment real estate or for real estate used in a trade or business.
Like-Kind Property
Like-kind is a
federal tax term relating to the nature or character of the real estate
in the hands of the owner rather than to its grade or quality. The fact
that the real estate is improved or unimproved is not material, for that
fact relates only to the grade or quality of the property and not to its
kind or class.
Qualified real
estate located in the 50 United States is of like-kind when exchanged
for other qualified real estate located in the 50 United States and the
U.S. Virgin Islands. The definition of "50 United States" means exactly
that. Any foreign real estate included in the exchange will be treated
as boot paid or received.
Time Restrictions
Under the
Regulations, two time limitation periods have been imposed on deferred
real estate exchanges. One limitation requires Replacement Property to
be identified within a certain time. The other requires Replacement
Property to be received by the exchanger within a certain time period.
To successfully qualify for 1031 treatment, your exchange must satisfy
both tests.
In a deferred
exchange, any Replacement Property you receive will be treated as
property which is not like-kind to the Relinquished Property if:
(Don't make these mistakes)
1. The
Replacement Property is not "identified" before end of the
"identification period", or
2. The
identified Replacement Property is not received before end of the
"exchange period".
3. The
identification period begins on the date you transfer the Relinquished
Property and ends 45 days after.
4. The
exchange period begins on the date you transfer the Relinquished
Property and ends on the earlier of 180 days after or the due date
(including extensions) for your tax return for the taxable year in which
the transfer of the Relinquished Property occurs.
Replacement Property
Replacement
Property must meet exacting identification and receipt requirements.
(Replacement Property is the property or properties intended to be
purchased with the funds that are received from the sale of the
Relinquished Property). There are limitations on how many replacement
properties you may identify in the same deferred exchange, no
matter how many relinquished properties you transfer.
The penalty for
violating the permitted maximum is severe. You are treated as not having
identified any property within the identification period and the entire
exchange will fail.
You may identify
more than one property as Replacement Property subject to three rules:
the 3-property rule, the 200% rule, and the 95 percent rule. You only
have to satisfy one of these rules—not all of them.
The 3-Property Rule
The maximum number
of replacement properties you may identify is three properties without
regard to fair market values of the properties.
The 200 Percent Rule
You may identify
any number of properties as long as their total fair market value does
not exceed 200 percent of the total fair market value of all
Relinquished Properties.
You figure fair
market value of Replacement Property as of the end of the identification
period. You figure fair market value of Relinquished Properties as of
the date you transfer them.
If, as of the end
of the identification period, you have identified more properties as
replacement properties than permitted, you are treated as if no
Replacement Property has been identified.
The 95 Percent
Rule
You may identify
any number of Replacement Properties if during the Exchange Period you
actually received identified Replacement Properties having a fair market
value equal to or more than 95 percent of the total fair market value of
all identified Replacement Properties.
Exchange or Sale?
The intent of the
deferred property exchange is that you have an actual continuation of
your old property investment into your new replacement property. To
qualify, you must follow the rules and requirements of Section 1031 of
the Internal Revenue Code. Intent does not count. What you actually do,
determines if you qualify.
Exchange
Requirements
Section 1031
requires an actual exchange of properties. If you simply sell your
property and reinvest the money in another property, you will not
qualify for exchange treatment, even though it is a simultaneous close.
The secret of a
successful deferred exchange is avoiding receipt of money or other
property during the transaction. If you receive the cash proceeds from
the exchange of your property, you will not qualify for 1031 treatment.
While this may sound easy to avoid, it's not. You must overcome the
doctrine of "constructive" receipt. The general rules concerning actual
and constructive receipt apply to determine if you are in actual or
constructive receipt of money or other property before you actually
receive like-kind Replacement Property.
The above information is a brief overview of the requirements of a
IRS Reg
1.1031(k)-1
tax deferred exchange and is not intended cover all areas or
consequences of the regulation. Please read the disclaimers below:
"Every effort
has been made to offer the most current, correct, and clearly expressed
information. Tax laws, regulations and rules change frequently.
Accordingly, this information is not intended to serve as legal,
accounting, or tax advice. You are encouraged to consult with
professional tax advisors for advice concerning specific matters before
making any decision!
State and local tax
matters are not considered here. These tax liabilities may be large
enough to influence your tax planning and should be considered when
working with your professional tax person."
This article is designed to provide accurate information
in regard to the subject matter covered. It is provided with the
understanding that the publisher is not engaged in rendering legal,
accounting, or tax services. If legal advice or other professional
assistance is required, the services of a competent professional person
should be sought.
For more information on opportunities on Grand Junction Commercial Real
Estate, please contact me! |
