By Bruce Cathcart
Section 1031 of the Internal Revenue (Federal Tax) Code allows for the taxes to be deferred on an exchange of like-kind properties. It is the real estate investor’s best friend when it comes to trading up, diversifying, leveraging or relocating their investments without having to pay capital gains tax on the transfer. By exchanging your real estate investments for other real estate investments, rather than just selling them, an investor can avoid paying capital gains tax on their holdings until such time as they do just sell them. As long as the property you get in the exchange is of equal or greater value than the property you give in the exchange, you pay no capital gains taxes!
I did my first exchange (as a Realtor helping a client) in 1983. Even though the ability to defer the gain on a sale had been around since 1921 it was a time when the IRS had still not clearly defined the rules for 1031 tax deferred exchanges and was regularly challenging those who chose to take advantage of the opportunity to do so. The most famous of which was the Starker family who won their challenge from the IRS and established better defined regulations for modern 1031 tax deferred exchanges.
Today the rules and regulations for 1031 tax deferred exchanges are well defined and as such 1031 exchanges have become common place in today’s real estate investment strategy. “Like-kind property” has been loosely defined to be an exchange of real estate held for investment for real estate held for investment. A vacant lot exchanged for a rental house, or rental house exchanged for apartments, etc. Now before I go too far here, I must remind you all that I am a real estate broker and not an accountant or tax attorney so this is not tax or legal advice I am dishing out, just real estate information. But you get the idea about like-kind property.
A true exchange of property would require that someone has a property that you want and you just happen to have a property that they want… possible, but unlikely. Going back to my first exchange in 1983 we had 4 different properties and 4 different investors and their brokers involved in order to get everyone a property that they wanted! It was called a “stew pot” where everyone put their deed into the pot (escrow) and then everyone got the deed to the property that they wanted out of the pot. The key to the success of this type of exchange was that each participant was exchanging a deed for a deed. The Starker family simplified all of this by creating a delayed (or now called a “Starker”) exchange using an accommodator or “qualified intermediary”. This is how the majority of 1031 exchanges are done today. The investor (exchanger) lists and sells their property but before closing escrow inserts the accommodator in as the seller. The accommodator receives the proceeds of the sale (NOT THE INVESTOR) and holds them in a trust account. The investor then finds a new property and negotiates the purchase substituting the accommodator as the buyer. The accommodator uses the investor’s proceeds held in trust to purchase the new property and then deeds the new property to the investor at the close of escrow, thus allowing the investor to exchange a deed for a deed. The IRS now has specific rules for the timing of this type of exchange. The investor must identify the property to be acquired within 45 days from closing escrow on the original property and then the investor must close escrow on the new property within 180 days from closing escrow on the original property. To make exchanges even easier there are many professional companies that specialize in 1031 accommodator services.
These are just some of the basics about 1031 tax deferred exchanges. For more information you can go on line and search “1031 tax deferred exchange” or as always contact your trusted real estate agent.
This week’s real estate tip: The 1031 tax deferred exchange can be used for investment properties and second homes that can ultimately be converted into a primary residence. This can have some very significant retirement/exit strategy benefits. There are very specific rules regarding this type of strategy and so investors considering this should consult not only with their trusted real estate agent, but also with their tax accountant and tax attorney.
Bruce Cathcart is the Broker/Co-Owner of La Quinta Palms Realty, “Your Friendly Professionals” and can be reached by email at firstname.lastname@example.org or visit his website at www.laquintapalmsrealty.com.