Tax Deferred Exchanges
Generally, capital gains from exchanges of real property are taxed under the Internal Revenue Service code (IRC) some type of exchanges, however, do not result in tax. IRC Section 1031 provides that no gain or loss will be recognized on an exchange of real property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment IRC 1031 (a)(1). This includes an undivided interest in real property. The exception is that exchanges between related parties do not qualify for tax deferral unless the replacement property is held for at least two years. And, on the sale of personal residence no tax is owed on gains of $250,000 and $500,000 for individual and married couples, respectively.
A typical 1031 tax deferred exchange involves 3 parties. The seller of the relinquished tract, the seller of the replacement tract and a Qualified Intermedia (QI). A QI cannot have worked for the seller for the previous two years (can’t use your Attorney or CPA). To qualify as a 1031 tax deferred exchange, the selling party must enter into an Escrow Agreement with the QI. The relinquished property is then sold. The seller has 45 days (the “identification period”) which begins on the date of the sale and ends at midnight of the 45th day thereafter, to identify a replacement property. The identification must be made in writing to the QI by hand delivery, mail, fax or otherwise. A copy of the contract for the replacement property with a legal description or property address is sufficient. The replacement property must be purchased within 180 days of the sale of the relinquished property.
An exchange can qualify for tax deferral even if the seller hasn’t sold the relinquished property yet. This situation is called a reverse 1031. Here, the seller buys the replacement property first. The replacement property must be held by an Exchange Accommodation Title holder. The time limit is the same as a straight 1031, 180 days. So, the relinquished property must be sold within that 180 day time period. With the use of an EAT a seller can also have improvements constructed on the replacement property. To qualify for tax deferral, the improvements must be made within the 180 day period.
1031 tax deferred exchanges are a great tax planning tool for any real estate investor. So be sure and ask your real estate agent for the name of a good QI and EAT.