Real estate investing success brings with it one notorious problem tax liabilities from your profits. However, by using part of the IRS tax law specifically a “Section 1031 Tax Deferred Exchange” you can legally stave off the taxman. There are a number of legal hoops that the IRS makes you jump through to complete a tax-deferred exchange. Here are the nuts and bolts of it.
A tax-deferred exchange allows us to sell a piece of investment property, buy a new property with the profit from the sale, and not owe taxes on the sale immediately. If you eventually sell the new piece of property, you would owe taxes at that time. Generally the exception lies where the property sold is traded or exchanged for “like-kind” property. The new property is seen as a continuation of the original investment, so taxes are not due at the time of the sale.
Let’s look at how one of these deals would work. Assume that you own an investment property that has gone up in value. You’d like to sell this property and then reinvest the proceeds into some other rental real estate. The difficult part of the tax deferred exchange is that the property you are going to purchase must be identified within a certain amount of time, and the transaction must close within a certain amount of time after it is identified.
You must identify exchange property in a written document signed by you, and delivered to the party assisting you with the exchange (cannot be related to you!) on or before 45 days from the date you sold the original investment property. You can identify more than one property as the replacement property.
The maximum number of replacement properties that you may identify is three properties. You also may identify any number of properties provided that the total value of these properties is not more than 200% of the value of the original property you are selling. You don’t have to close on all the properties you identify. You can name several if you’re not sure what will close, or not close, as long as the properties you actually close on meet the requirements of the exchange.
Once you have identified the exchange properties, you have up to 180 days to complete an exchange, but the period may be shorter. You have 180 days after the date you transferred the property you are relinquishing or after the due date of your IRS tax return (including extensions) for the year in which you made the transfer. For multiple property transfers, the 45-day identification period and the 180-day exchange period are determined by the earliest date a property is transferred.
One major item to be aware of is “Boot”. Boot is defined as any money or any type of property of unlike kind (example, a car received as part of down payment). You will be taxed on this boot regardless of whether or not you carry out the exchange correctly. You will want your exchange company, or attorney to examine your transaction closely to make sure you don’t receive anything that could count as boot. Special rules apply for exchanging property with assumed mortgages.
When you get ready to do a tax-deferred exchange, you will need the services of a qualified CPA or Attorney.
You will need to search out a good intermediary. There are dozens of companies many national in scope that facilitate 1031 Exchanges. Many CPAs and Attorneys can also act as the “disinterested party.”
The tax-deferred exchange is a great way to maximize your wealth. By keeping your investments growing without immediately paying taxes, you can do wonders for your net-worth. Keep your money working for you.