Posted by James Financial Services Inc

Like-Kind Exchange

Like-Kind Exchange

Suppose you have an investment property, such as a house, apartment, condominium, or commercial property that you rent out. In that case, you usually have to pay capital gains tax on the gains when you sell the property. But you can defer your obligation to tax capital gains by making a 1031 exchange, which is a like-kind exchange for another property of equal or greater value. The rules are complicated, the deadlines are tight, and it is easy to make mistakes that can lead to a large tax collection or a rushed purchase that may not be a good investment. Here's what you need to know to complete a 1031 transaction for yourself and to find an expert who can help you with the transaction.

What is a 1031 exchange?

If you own a commercial or investment property, you can benefit from a 1031 exchange. By purchasing another similar property of equal or greater value, you can defer the collection of capital gains tax in the future, or you can avoid capital gains taxes on death before selling the last property.

You can apply for the 1031 exchange if you file your taxes as a C corporation, limited liability company, an individual, S corporation, or other types of entities. Any taxpayer who owns real estate and can meet the requirements of Section 1031 can defer gains or losses. The provision is not limited to certain types of taxpayers.

Exchange 1031 can be particularly useful if you want to sell your property now but expect the capital gains tax rate to be lower in the future. For example, this can be useful if you are in your peak earning years but expect your tax rate to drop after retirement. And if you die before you sell the last property, your heirs may receive a basic increase and won't have to pay federal capital gains tax to increase their value over their lifetime. Rules may vary from state to state.

This does not apply if:

A 1031 exchange is for business investment and property, not your primary residence. Your home is subject to a different tax exemption, which could be more valuable if you have lived in your home as your principal residence for two of the last five years prior to the sale. You may exclude up to $250,000 from home sales tax if you are single or up to $500,000 if you are married, filing jointly and there's no need to purchase a new home or renovate it in order to benefit from the principal residence tax exemption. The income of $250,000 or $500,000 from the sale of your primary residence is tax excluded, not just deferred. Some people who own a house for rent end up moving into their primary residence for at least two years before selling it, so they can benefit from this exclusion instead of going through a 1031 exchange.

What type of property is eligible for the 1031 Exchange?

To defer all capital gains taxes, the new property's value must be at least equal to the value of the property you are selling. The taxpayer must reinvest all net sales proceeds from the purchase of one or more similar replacement properties of greater or equal value than the property sold.

The definition of "like-kind" is broad: the new property must also be property used for business or investment purposes but does not necessarily need to have the same building structure or land. Both properties should be focused solely on commercial or investment use. There is a lot of flexibility in this definition. The properties do not have to be of the same type or located in the same state. For example, a rental house in Texas can be replaced with an industrial building in Washington, and so on.

The mortgage balance should also be at the same level. If you had a mortgage on your old property, you should have a mortgage on your new property for the same amount or more.

The key is that you have to go beyond the property's market value or more and the level of debt. If these two elements are not respected, there will be a capital gain. However, you can defer part of the capital gain if you buy a new, lower-value property.

When is the deadline to find a new property?

You have limited time to identify the new property and close the sale. You have up to 45 days from the sale of the first property to identify certain properties that you intend to purchase for trade. You can usually identify up to three potential customers. You must complete the sale of one of these properties within 180 days of the first sale. If you don't fit in that window, you don't qualify.

Another important rule: you cannot touch money from the sale of the first property and still be eligible for the exchange; you must work with a qualified broker who ensures that the transaction meets IRS requirements. It is essential to find a qualified intermediary before selling your first property.

If an investor takes control of the proceeds from the sale, the 1031 exchange will be canceled, and you will have to pay taxes. The qualified broker has three main responsibilities to ensure that 1031 complies with IRS rules:

  • Hold the investor's cash gains from the sale of the property per IRS requirements.

  • Document identification of the investor's replacement property within 45 days.

  • Facilitate and document the investor's purchase of replacement property by transferring funds from the investor to the security company/seller.

The family of taxpayers, employees, accountants, lawyers, real estate, and investment brokers cannot act as facilitators. Still, a chartered public accountant or real estate broker can usually recommend a facilitator. 

Is the Like-kind exchange right for you?

A 1031 exchange can be especially useful if you are in a high tax category and want to defer property sales tax later when you plan to fall into a lower tax category. For example, if you are currently above your income but expect your income to decline when you retire in a few years, this may be the right decision for you.

Like-kind works best if you die before the last property is sold. If this is the case, you can avoid withholding a capital gains tax, and the tax basis will be 'increased' to the value for your heirs upon your death, thereby eliminating capital gains taxes on the estate. For people with more than enough savings which will never need the money, this is a great intergenerational planning tool.

Also, think about what might happen to capital gains tax rates in the future. There are times when 1031 can be of great benefit, but you have to assess where you are at.

The rates of capital gain are now very low (0%, 15%, or 20%, depending on income, for assets owned for more than a year) and could increase in the future. Suppose you know that you will need the money from the property's sale soon and are now in a low capital gains streak. In that case, we recommend that you think carefully before making an exchange instead of paying taxes now. If you have a lower capital gains rate, it might be a good idea to take advantage of those low rates. 

Bottom Line

With such a tight timeframe for exchange, try to do as much as possible in advance. If you have a real estate investment, it is a good idea to meet with a financial advisor, such as JAMES FINANCIAL SERVICES, INC. well before considering selling your property to learn more about how a 1031 exchange works and what types of properties would work. Think about when you might work best with taxes if you eventually had to sell the property for cash and pay capital gains tax, such as in a year when your income is low.



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