Quite often, taxes are an obligation most people prefer to pay on a minimal basis. Taxpayers will give their best effort to reduce the portion of their income payable to Uncle Sam. While it is possible to discover loopholes that will reduce total tax owed, maximizing after-tax income can take a considerable amount of time, expenses and creativity. In regards to the sale of property, particularly in real estate, a 1031 exchange is increasingly being recognized for its tax benefits to investors of all levels. (For more, see 10 Things to Know About 1031 Exchanges.)
1031 Exchange Explained
A 1031 Exchange is an exchange of like-kind properties in the United States, in which the property being sold is not subject to capital gains tax until it is eventually sold without reinvestment of the proceeds. Essentially, this allows not for the avoidance, but the deference of any taxable gains on the property that is first sold. In a 1031 exchange, both properties must be held for business or investment purposes and be located in the United States. They must be similar in nature while the quality of the property is irrelevant. Corporations, partnerships, limited liability companies and trusts are eligible tax-paying entities that can establish an exchange under Section 1031. (For more, see Avoid Capital Gains Tax on Your Home Sale.)
In the case of personal property, the selling of a residential home for another wouldn’t be allowed under the 1031 exchange guidelines. Moreover, there are specific types of property that also aren’t eligible: items such as business inventory, stocks, bonds, debt notes, securities, interests in partnerships and certificates of trusts do not qualify for a 1031 exchange.
To be authorized as a 1031 exchange, the transaction must be contingent on the attainment and relinquishment of each respective property. Typically, the parties use exchange facilitation companies, which assist in managing deals of this nature to ensure they are carried out properly. Fortunately, a like-kind exchange doesn’t have to be completed simultaneously; however, it does have a few time limitations that must be followed.
First, the taxpayer has 45 days from the time the property is sold to identify possible replacement properties. A written notice of this identification must be signed and delivered to the seller or qualified agent of the desired property. For real estate, the documentation must include specific details about the property, such as the address and legal description. Next, the replacement property must be secured, with the exchange finalized no later than 180 days after the sale of the original asset or the deadline of the income tax return for the tax year the original asset was sold – whichever comes first. The property must be of very similar description to the one mentioned during the initial 45-day timeframe.
Now that you know more about a regular 1031 exchange, it is important to know that a reverse exchange is also possible. The appeal of this type of exchange is that the taxpayer can take as much time as needed to purchase a property as deadlines aren’t enforced until the property is officially acquired and recorded with an Exchange Accommodation Titleholder. Technically, this is an agent who holds the legal titles of property until the swap is completed. The real estate investor has 45 days to specify which property he or she want to sell, which is often already known, and another 135 days to complete the sale of the renounced property. The reverse exchange provides yet another method for taking advantage of this unique tax benefit.
With all of the previous conditions being satisfied, there are also administrative requirements that must be documented and tracked. The gain from the original sale of the first asset must be recorded so if the replacement asset is sold, both gains are taxed with a few adjustments. The IRS requires that 1031 exchanges be tracked on Form 8824, which specifies details about the transaction. The form itself requests descriptions of the properties that were exchanged, dates of when acquisition and transfer, how the two parties of the exchange are related and the value of both properties.
Additionally, the form requires the declaration of the gain or loss on the property sold as well as the cash received or paid and liabilities, if any, from the transaction. Lastly, the basis, or cost with necessary additions and deductions, of the original property must be listed. IRS Publication 544 also provides additional details about the sale and disposition of assets and their appropriate tax treatment.
The Bottom Line
For many people, the subject of taxes can become confusing awfully fast. Taxes can go from simple to highly complex with just the addition of a few pieces of property. However, being educated on what effective tax rules are available can be an asset in itself. A 1031 Exchange is a section of the tax code that can reward individuals engaged in certain business and investment activities. (For more, see Use Real Estate to Put Off Tax Bills.)
This unique channel of tax-deferred growth can empower individuals by allowing them to exponentially grow their wealth if used correctly. Rather than paying taxes when a capital gain is realized, these proceeds can be reinvested into an asset of similar or higher value. Ideally, this process can be repeated by using the funds for the acquisition of property instead of paying the IRS, resulting in accelerated growth. Reverse exchanges offer even further flexibility of this rule, opening up more options for investors.
The paperwork necessary to track this type of transaction is thorough, but don’t let that be a detractor. Lastly, be mindful of the timeframes and deadlines during which property can be bought and sold. Missing these crucial windows can be the difference of paying up to 35% in taxes or increasing your net worth. Ultimately, the 1031 exchange is a completely legal tax-deferred strategy that any taxpayer in the United States can use. Over the long term, consistent and proper use of this strategy can pay substantial dividends for years to come.