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!

Tax Deferred Exchange Tips

Build To Suit

What happens when you cannot find a replacement property that is worth the same price of what you sold in a 1031 exchange? One option is to make improvements to the property being purchased. You can literally build the property to suit your needs or the needs of a potential tenant.

Essentially, you can use exchange funds to pay for the improvements made to the property that can be accomplished before the 180^th day of the exchange. It is almost that simple if you are only dealing with a sale that is free and clear. The only factors that can complicate this have to do with debt and lending issues.

The Process?

In simple terms, the Qualified Intermediary (QI) steps into title during the initial purchase, acts as a general contractor to facilitate the payment of improvements, repairs, and even some personal property that is added property. Then, as soon as the work is completed, or we reach the 180^thday, that improved property is conveyed to the exchanger to complete the purchase leg of the exchange.

What Improvements Can Count?

Virtually any capital improvements can count towards the value being added to the property. The QI cannot directly pay the exchanger for labor and the value of improvements is simply their cost. As mentioned earlier, personal property can be included, as long as its value does not exceed 15% of the total value of the finished property. An extreme example was the purchase of a fork lift for use in a warehouse being improved in an exchange, or a lawn mower purchased for a rental.

What If the Improvements Are Not Completed?

The property does not need to be habitable to qualify; it simply needs to be attached. A lumber package sitting in the driveway is only personal property until it is attached to the land. There is no inspection required; you only need proof that the money was spent. Guidelines and case examples use the “snap shot rule”. In other words, if you were to take a photo on the last day of the exchange, whatever is visibly completed can be counted.

Use of an LLC

Very often forming an LLC for the process of an Improvement Exchange is an effective way to package the improvements and tie them to the property. Any agreements made with any contractors during the process would remain in effect, and the final transfer of the improved property are smoothly conveyed by a simply Assignment of LLC Interest. 

 Happy Investing!

Today's blog is courtesy of Kevin Hummel, McFerran & Burns, PS.