Step-by-step: How to Defer Your Real Estate Taxes Using a 1031 Tax Exchange

The 1031 tax exchange real estate transaction is an excellent strategy for deferring taxes but should not in anyway be thought of as avoiding paying taxes. There are a number of key components to be mindful of when considering a 1031 exchange. First and foremost you should consultant a good tax accountant or tax attorney before going this route. The guidelines are strict and apply to specifics when selling and buying investment properties. Balancing your financial options will be at the root of any good decision.

Let’s take a look at some of the key components in making these decisions. What kind of property qualifies as a 1031 tax exchange? Although the 1031 can be used for many types of properties for our example the focus will be on investment real estate. Under the rules of the 1031 exchange there is a concept of like kind but as long as we limit our discussion and transactions to investment property the pitfalls of not meeting the like kind standard can be avoided.

Before going any further there are a few other basic principals that should be discussed, for example, how to do the math. As stated the primary purpose of taking advantage of a 1031 transaction is tax deference. The tax in this case is on the capital gain of the actual sale of real property. Thus if there is no capital gain, executing a 1031 transaction has no value. On the other hand, depending on the strategy and the exchanger’s financial position, in order to defer paying tax on a gain, the replacement property must be equal to or of greater than the value of the relinquished property.

In order to understand capital gain and the concept of equal or greater value it is important to understand the interaction between original purchase price, expenses, basis and sales price. In addition there are terms such as Relinquished Property and Replacement Property; and because we are dealing with investment real estate the math can be a little challenging. For example:

  1. Calculate Net-Adjusted Basis:

a. Original Purchase Price $800,000

b. Plus Capital Improvements $50,000

c. Minus Depreciation Taken ($350,000)

d. Equal Adjusted Basis $500,000

  1. Calculate Capital Gain

a. Current Sales Price $1,200,00

b. Minus Exchange Expenses ($30,000)

c. Minus Adjusted Basis ($500,00)

d. Equals Capital Gain $670,000

  1. Calculate Capital Gain Tax

a. Gain Attributed to Depreciation $87,500

· $350,000 x 25%

b. Plus Federal Capital Gain Tax $48,000

· $670,000-$350,000=$320,000 x 15%

c. Plus State Capital Gain Tax $67,000

· E.g. CA; 10% x $670,000

4. Bottom Line

Relinquish Property

Example

Replacement Property

Example

Sales Price

$1,200,000

Purchase Price

$1,600,000

Minus Existing Loans

$350,000

Minus New Loan

$780,00

Minus Exchange Expenses

$30,000

Equals Minimum Down

$820,000

Equal Net Proceeds

$820,000

 

 

Study the above table to get a feel for how the different terms affect the math of the transaction. Then follow the below steps to understand the basic process on how to conduct a 1031 exchange.

STEP ONE: Put the property to be relinquished on the market. However, before the close, of the sale make sure your real estate agent designates a Qualified Intermediary to handle the transaction. The exchanger in no way is allowed to handle the proceeds of the transaction. To do so will disqualify them from the advantages governing the 1031.

STEP TWO: Within 45 calendar days of the closing identify your replacement property. Remember there are no extensions. If you fail to designate a replacement property you will have to pay Federal and State capital gain tax. Step one and two requires specific paperwork. It is critical your real estate Agent communicates well with the Qualified Intermediary in this regard.

The rules governing the fair market value of the property or properties you designate are specific. In some cases it might be to your advantage to designate more than one property. Again, there are specific rules and here is where your professional help will come into play.

STEP THREE: Within 180 calendar days of the closing date on the relinquished property or the exchanger’s tax filing date whichever is shortest you must have acquired your identified property or properties. The number of properties you designate is directly related to your wealth building strategy. Also, although there are no extensions allowed beyond 180 calendar days one is able to get an extension on filing taxes to bring the timeline within the 180 days given to execute the 1031.

There are many variations of the 1031, such as the reverse exchange or an exchange involving corporations, spouses, other related family members and/or trust. The 1031 tax exchange process is one of the last if not only means to defer taxes when selling investment property. It is a great tool and especially in states like Hawaii and South Carolina where taxes on non residence or foreign nationals can be pretty steep. It can help in how you approach your follow up investment.

Before closing lets touch briefly on a few of these topics. The Reverse Exchange for example is when the replacement property is acquired before the sale of the relinquished property. In this case, in addition to using a Qualified Intermediate the exchanger must secure the help of an Exchange Accommodation Titleholder to hold tile of either property. As with the regular delay exchange the reverse exchange, the sale of the relinquished property must be completed within 180 days of purchasing the replacement property.

To address exchanges involving corporations, spouses or trust it is important to note in order to correctly exchange investment property title to the replacement property should be held exactly the same as the relinquished property. So the following would be disallowed:

Husband relinquishes and husband and wife acquire property of equal value.

X Corporation relinquishes and Y Corporation acquires.

Partnership X relinquishes and partners acquire as individuals.

Partnership X relinquishes and Partnership Y acquires

The following are examples of some exception that apply:

Husband and wife are trustees of a revocable trust living trust. Trust relinquishes property and husband and wife acquire individually.

Sole member of an LLC relinquishes and sole member acquires.

Individual relinquishes and individual estate acquires due to death of the individual.

Trustee of a revocable trust living trust relinquishes and Trustees acquires as an individual.

As one can see the rules can be quite complex. None the less the 1031 tax exchange is a very use for tool when it comes to planning your financial strategy. Yet as mentioned before making a full commitment a good tax accountant or tax attorney should be consulted. If done properly it will allow the user to have additional cash to use with their next purchase.

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Abron Toure
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Posted on Jan 31, 2009