In a typical real estate sales transaction, the property owner/taxpayer is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.*
Under Section 1031 of the United States Internal Revenue Code, the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due. Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment.
Translation: A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of like-kind, while deferring the payment of federal income taxes and some state taxes on the transaction. Both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify, nor will the taxpayer's personal residence. If your property is a vacation property which you also rent, it will qualify. All qualifying real property located in the United States is "like-kind". Property outside the United States is not "like-kind" to property located in the United States.
Example: A seller decides to sell his Loon area vacation rental property to purchase a vacation rental property in Myrtle Beach. That seller can opt to perform a 1031 Exchange whereby at closing, the proceeds from the Loon sale are immediately invested into the Myrtle Beach property, and any taxes on the capital gains resulting from that sale are deferred until some future date.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
-when you list your property for sale, you need to let your real estate agent know that you will be performing a 1031 Exchange as language to that effect needs to be included in the Purchase and Sales Agreement.
-all proceeds from the sale of the relinquished property are wired directly from the closing to a Qualified Intermediary (QI). The seller may not receive the proceeds or take constructive receipt of the funds in any way without disqualifying the exchange.
-within 45 days after the date that the relinquished property is transferred, a replacement property must be identified, the value of which must be equal to or greater than the value of the relinquished property
-within 180 days after the date that the relinquished property is transferred, the exchange must be completed, meaning that the sale of the replacement property must be closed within that timeframe.
What is a Qualified Intermediary (QI) and why are they needed?
A Qualified Intermediary is an independent party who facilitates the tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code. Acting under a written agreement with the taxpayer, the QI acquires the relinquished property and transfers it to the buyer. The QI then holds the sales proceeds to prevent the taxpayer from having actual or constructive receipt of the funds. Finally, the QI acquires the replacement property and transfers it to the taxpayer to complete the exchange within the appropriate time limits.
The use of a QI is a safe harbor established by the Treasury Regulations to ensure that the taxpayer does not take actual or constructive receipt of the proceeds from the sale of the relinquished property, which would end the exchange.
Exchanging vs. Selling:
-a 1031 Exchange is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of qualifying properties.
-by deferring the tax, you have more money available to invest in another property.
-any gain from depreciation recapture is postponed
-you can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.
Ultimate use of the property:
The replacement property can eventually be converted to the taxpayers primary residence or vacation home, but the holding requirements of Section 1031 must be met prior to changing the primary use of the property. The IRS has no specific regulation on holding periods. However, many experts feel that to be on the safe side, the taxpayer should hold the replacement property for a proper use for a period of at least one year.
*Always consult a competent Qualified Intermediary, attorney, or tax advisor to determine how an exchange may best be structured to accomplish your investment objectives.
For more information regarding 1031 Exchanges, please contact Jay Polimeno, Principal Broker of Loon Mountain Real Estate Company at firstname.lastname@example.org.