1031 Exchanges: How to Defer Tax on Your Investment Property

A 1031 Exchange (also called a Starker Exchange or Like-Kind Exchange) allows investors reinvest gain into a similar property and avoid tax now. In addition to saving on taxes, a 1031 Exchange also allows investors to shift the focus of their investing without tax liability. As an example, you can shift investments to markets, buy newer, lower maintenance properties, or move into larger multi-family or commercial properties.

1031 Exchanges Can be structured 4 ways:

  1. Simultaneous sale of old property and purchase of new property – closing occurs on same day and may involve actual exchanges of titles between 2 property owners.
  2. Delayed exchange – Original property sold first, new property acquired within a specific time frame. later. A Qualified Intermediary holds fund in a trust until purchase of new property is completed.
  3. Reverse Exchange/Forward Exchange – Replacement property is acquired before original property is sold. Taxpayer has 45 days to identify the property they plan to sell, and 135 days after that date to sell it.
  4. Construction/Improvement Exchange – This method allows the taxpayer to use the sale proceeds to make improvements on the identified acquisition property during the 180 days funds are held by the intermediary. Improvements must be completed before taxpayer takes title and the property must be equal or greater in value when purchase is completed.

If you are considering a 1031 exchange, there are many rules you need to know:

  1. The definition of like-kind is broad. The properties must be of a similar nature, even if different in grade or quality. 1031 exchanges only apply to investment property, not your personal residence. Real property cannot be exchanged for personal property. A rental home can be exchanged for a duplex, apartment building, commercial rental, vacation home or even unimproved land. Trading depreciable property for land has some special rules and may result in recapture of depreciation.
  2. You have 45 days to identify replacement property – The seller has 45 days after closing on the original property to identify up to 3 possible replacement properties. Alternatively, the seller can identify 4 or more properties if the total value of these properties does not exceed 200% of the value of the properties sold.
  3. You have 180 days to complete the purchase of the replacement property – closing on the purchase of the related property must take place the earlier of 180 days after the sale of the original property or the due date (with extensions) of the income tax return for the tax year in which the original property was sold.
  4. Properties must be located within the U.S.
  5. You can include more than one property, so you can sell multiples properties and buy one large one, or vice-versa.
  6. The net market value and equity in the property purchased must be the same or greater than the property sold in order to defer 100% of the tax. Acquisition and sale expenses are included in these calculations, so it is important to retain original closing documents for the life of the investment.
  7. You can’t touch the cash, proceeds from the sale go to a Qualified Intermediary and are held until you close on the replacement property. It is possible to do a partial exchange and take out some money for other projects, but this money is taxable. Likewise, if there are funds left over after closing on the 2nd property, you will receive the money back and it would be taxable.
  8. The names on the tax return and titles of the properties must be the same. The only exception is a single member LLC. Because the IRS consider LLC’s to be pass through entities, SMLLCs can sell the original property and the sole member can purchase the new property.

You should carefully consider the Qualified Intermediary you want to use for your exchange. Most large banks and title companies have special departments to handle these transactions. Reputation matters here, as some of these companies have gone out of business while holding client funds, so I would not recommend choosing an online company unless you have been thorough in your research. It is also a good idea to discuss this transaction with a tax professional prior to starting the exchange process. Not every exchange goes as planned and there are some alternatives that may be a better fit than reinvesting in rental property.

Contact a CPA for Help With Your Investment Properties in Denver Today!

At Karen Schwimmer, CPA we specialize in small business taxes in Denver; helping reduce tax liabilities for small business owners, medium sized business owners, and owners of investment properties. We also help small business owners find ways to improve their profits and manage their cash flow. Contact Karen Schwimmer, CPA, EA today or giver Karen a call at 303-642-0628.

This information is provided for general information only and should not be construed as specific tax advice as your situation may vary.

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