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1031 TAX DEFERRED EXCHANGE
IT MIGHT BE A PERFECT FIT
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Compiled from a series of reports submitted by experts in this area.
hat is the 1031 Exchange?
Actually, deferred exchanges have been around since 1921 in one form or another, but many people don't know about them, or think they understand them
and don't.
Some characterize the 1031 Exchange as an interest-free loan from the government to invest in real estate, as long as it's not your primary residence or a property held primarily for personal use.
First, remember to discuss this with your real estate professional, if that individual has substantial experience in 1031 exchanges. If he or she does not, find someone who does.
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ere are a few thoughts to get you started.
According to real estate experts Reginald and Anita Hill, suppose you want to sell a real estate investment property in New Jersey and buy a beach house for rental investment in the Carolinas. The vehicle they would suggest is the 1031 Tax Deferred Exchange.
"What is required to implement this strategy is a "Qualified Intermediary," says Mr. Hill, noting that the QI will hold the proceeds from the sale of that New Jersey "Relinquished" property until you purchase your "Replacement" property on the coast.
"In order to defer all capital gains taxes, you must reinvest all the net proceeds from the sale of the Relinquished property and acquire a Replacement property of equal or greater value," he explained.
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Here is an example from Reg and Anita Hill. Bob and Joan decided to sell
their investment property in Ohio and reinvest in a rental investment
condominium at Sunset Beach, North Carolina. |
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They consulted their tax advisor, engaged the services of a QI, sold their highly appreciated land in Ohio, and bought an income-producing rental investment condominium at Sunset Beach. They were able to protect their profits in the land sale and defer their capital gains through the purchase of the Sunset Beach property.
According to Jordan Kanter, Vice President of LandAmerica 1031 Exchange Services, the 1031 Exchange is not a dubious tax shelter scheme or loophole. It is an express section of the tax code that allows owners of investment and business property to transition into new property that better suits their needs going forward. For example, "Allowing the owner of a growing business to move into a newer and larger manufacturing facility, without a debilitating capital gains setback, facilitates that business’ expansion. This, in turn, can lead to the creation of new jobs, as well as significant revenue for the government from other sources, such as the additional income and sales taxes that will be generated from the increased commerce”, he explained.
Mr. Kanter says that this growth, in turn, creates more opportunities for that company's suppliers,
as well as the realtors and transactional services companies who are involved in the relinquished and
replacement property transactions. He indicates, however, that “…a tax-deferred exchange is not a
reason to sell property in and of itself. Rather, it is a means by which another goal or purpose can be
achieved for a particular investor or business property owner”.
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Among the common motives for doing a 1031 exchange are: |
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1.
upgrading into a larger facility;
2.
consolidating many smaller properties into a larger, higher quality property with less management burdens;
3.
diversifying one's holdings from a single, large facility to a group of smaller ones in different regions;
4.
moving investments to a location closer to where the investor lives, or is relocating;
5.
or simply re-investing into a hotter market.
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There are strict timeframes under which the taxpayer must identify prospective properties. This referred to as the 45 day rule.
According to Mr. Kanter, in a typical delayed exchange, the 45-day period to identify replacement property begins running from the date of the closing of title on the exchanger's relinquished property. During this time, the exchanger must specifically identify, in writing, the property or properties that they intend to purchase with the proceeds of their relinquished property during the remainder of the maximum 180 day exchange period.
If that doesn't happen, the exchange is over and the proceeds are taxable to the extent that they represent capital gain. However, if the exchanger does locate and properly identify replacement properties, he or she then has the remainder of the maximum 180 day exchange period to actually close title on that replacement property or properties. It is important to note that the 45 and 180 day rules refer to "calendar" days, not "business" days, and both begin running at the same time. The forty five day identification period is actually the first forty five days of the maximum 180 day exchange period.
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In addition to missing deadlines, there are a myriad other ways well-intentioned investors can lose this opportunity
for tax-deferral. |
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One fairly common one, according to Mr. Kanter, is when the exchanger closes title on their relinquished property before entering into an exchange agreement with a reputable qualified intermediary. It is absolutely crucial that the prospective exchanger sign an exchange agreement, along with other associated exchange documents, prior to, or during, the relinquished property closing.
As with all regulations governed by the Internal Revenue Code, there is no room for error or misunderstanding. That's why the above is intended as information, not advice. Before making any real estate-related moves, the advice of a qualified accountant and/or attorney is strongly recommended.
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A Different Tax-Deferred Option: Private Annuity Trust (PAT) |
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According to Reginald Hill, another useful tax deferral strategy is the PAT. With it, one can capture their profits in either their primary residence or investment property and implement several very beneficial estate planning strategies.
For example, suppose you have a primary residence in New Jersey that you bought many years ago, and you enter into a contract to sell it for a price significantly greater than your original purchase price. To utilize the PAT, you must first "assign" the contract to a PAT. When the contract closes, the cash is inside the PAT and is protected from a capital gains perspective.
"If you still have capital gains after applying your primary residence exemption, then the PAT allows you to defer immediate taxes on these gains," Mr. Hill explained. Basically, he says that if the transaction takes place inside the PAT, the capital gains are paid to the IRS over the person's lifetime rather than immediately. Another plus, he says, is that the entire value of the home, at the time of the sale, is forever removed from the couple's taxable estate.
Again, the above is information provided by those in the real estate business, however, use it to begin to think about your particular situation and goals for relocation and retirement. Consult your own experienced accountant and tax professional for in-depth, personal advice.
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Jordan E. Kanter, J.D., is Vice President of LandAmerica 1031 Exchange Services, a premier provider of intermediary services, located in Orlando, Florida.
Reginald Hill holds a Master of Economics Degree with a minor in Statistics and a Bachelor of Business Management Degree, both from North Carolina State University. He is a member owner of Lakewood Estate Planners, LLC in Oakboro, North Carolina.
Anita Hill is a Licensed Real Estate Broker, and Broker in Charge of Lakewood Real Estate Investments and a member owner of Lakewood Estate Advisors, LLC.
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