Defer Capital Gains Tax

There are two ways to defer capital gains tax on real estate profits. One way was discussed in my previous blog post - that is, to use seller financing to defer income from the proceeds of a sale on an income property.

The other way to defer capital gains tax on real estate is to make use of a 1031 tax exchange. What is a 1031 tax exchange?

According to Wikipedia, 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.

To qualify for Section 1031 of the Internal Revenue Code, the properties exchanged must be held for productive use in a trade or business or for investment. The properties exchanged must be of "like kind", i.e., of the same nature or character, even if they differ in grade or quality.

The challenge with a 1031 exchange is to meet the strict timelines identified by the IRS to qualify for an exchange.

The §1031 exchange begins on the earliest of the following:
the date the deed records, or the date possession is transferred to the buyer, and ends on the earlier of the following:
180 days after it begins, or the date the Exchanger's tax return is due, including extensions, for the taxable year in which the relinquished property is transferred.

The identification period is the first 45 days of the exchange period. The exchange period is a maximum of 180 days. If the Exchanger has multiple relinquished properties, the deadlines begin on the transfer date of the first property.

The following sequence represents the order of steps in a typical 1031 exchange:

Step 1. Retain the services of tax counsel/CPA. Become advised by same.

Step 2. Sell the property, including the Cooperation Clause in the sales agreement. "Buyer is aware that the seller's intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with seller to accomplish same, at no additional cost or liability to buyer." Make sure your escrow officer/closing agent contacts the Qualified Intermediary to order the exchange documents.

Step 3. Enter into a 1031 exchange agreement with your Qualified Intermediary, in which the Qualified Intermediary is named as principal in the sale of your relinquished property and the subsequent purchase of your replacement property. The 1031 Exchange Agreement must meet with IRS Requirements, especially pertaining to the proceeds. Along with said agreement, an amendment to escrow is signed which so names the Qualified Intermediary as seller. Normally the deed is still prepared for recording from the taxpayer to the true buyer. This is called direct deeding. It is not necessary to have the replacement property identified at this time.

Step 4. The relinquished escrow closes, and the closing statement reflects that the Qualified Intermediary was the seller, and the proceeds go to your Qualified Intermediary. The funds should be placed in a separate, completely segregated money market account to insure liquidity and safety. The closing date of the relinquished property escrow is Day 0 of the exchange, and that’s when the exchange clock begins to tick. Written identification of the address of the replacement property must be sent within 45 days and the identified replacement property must be acquired by the taxpayer within 180 days.

Step 5. The taxpayer sends written identification of the address or legal description of the replacement property to the Qualified Intermediary, on or before Day 45 of the exchange. It must be signed by everyone who signed the exchange agreement.

Step 6. Taxpayer enters into an agreement to purchase replacement property, again including the Cooperation Clause. "Seller is aware that the buyer's intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with buyer to accomplish same, at no additional cost or liability to seller." An amendment is signed naming the Qualified Intermediary as buyer, but again the deeding is from the true seller to the taxpayer.

Step 7. When conditions are satisfied and escrow is prepared to close and certainly prior to the 180th day, per the 1031 Exchange Agreement, the Qualified Intermediary forwards the exchange funds and gross proceeds to escrow, and the closing statement reflects the Qualified Intermediary as the buyer.

Step 8. Taxpayer files form 8824 with the IRS when taxes are filed, and whatever similar document your particular state requires.





If you are interested in learning more about how to do a 1031 exchange for the sale of your income property, please message me privately at HomeLandInvestment@gmail.com.




Happy Investing!