The Tax Code Makes It Possible To
Exchange Taxes for Profits
By Rich Vaill & Sunny Kancherla
Deferring taxes can be an excellent way to preserve your real estate portfolio and leave more wealth to your heirs. For many years, prudent investment property owners have been using Section 1031 of the Internal Revenue Code to save money when they sell an investment property.
After the sale of an investment property, this part of the tax code allows a person to make a “delayed exchange.” A delayed exchange allows a person to have a period of time to locate and close on the replacement property. It is called “delayed” because the replacement property has not been identified prior to the sale of your existing property. The delayed exchange allows owners of investment property to legally defer state and federal capital gains associated with the sale of that property.
In order to execute a delayed exchange taxpayers need to follow a few rules:
• The first thing to remember is that the exchange must be completed within 180 days from the close of escrow of the property that was sold. The time on the clock does not begin until the close of escrow on the sold property, but each calendar day is counted, including holidays.
• Upon the close of escrow, the taxpayer has 45 days to identify up to three potential replacement properties. Taxpayers are allowed to change their mind as many times as they wish within the 45 day period. However, once day 45 arrives, whatever property the taxpayer identified last must be used to complete the exchange. After this time the taxpayer will have an additional 135 days to actually close the transaction, thus completing 180 days.
• In finding an appropriate replacement property, the taxpayer must purchase property that is at or higher value from the relinquished property. The taxpayer must also replace the same or higher amount of debt that exists on the replacement property. Any discrepancy in this area will subject the taxpayer to taxation on that portion only.
The tax code allows investment property owners to consolidate or expand their real estate holdings. For example, an older couple who own several residential units may be interested in consolidating them all into one single property due to the ease of management.
In order to complete a delayed exchange, two things must be observed. First, it is necessary to use a disinterested third party to hold funds between the sale of the relinquished property and the purchase of the replacement property.
The third party cannot be your attorney, CPA, escrow holder, or real estate broker. Using any of these individuals will disallow the exchange. Secondly, you will need to have a series of documents out-lining the exchange and they need to be signed by both the seller and buyer of the property.
There are companies that specialize in providing this service and are known as qualified intermediaries, exchange companies, or accommodators. Exchange companies provide clients with experienced professionals dedicated to assisting tax-payers with completing their exchange. These companies will provide the necessary documents and will coordinate the transaction with the closing agents and real estate professionals. Often these companies have extensive insurance and banking programs designed to make the exchange safe and efficient.
Next time you plan on selling your investment property, think about the potential of a section 1031 exchange. The savings can be significant and with the assistance of exchange companies, the process is easy.
