1031 Tax Exchange Real Estate Information
Whether putting money in offshore accounts, claiming tax exemption and write-offs, or just pulling an Al Capone-style evasion, investors are always trying to save money on federally mandated taxes. Created as a tax incentive for Americans to invest their capital in American properties, the 1031 property exchange is a completely legal way to do so. Outlined in Section 1.1031 of the IRS Code, these exchanges follow strict guidelines in order to defer and minimize taxes, not evade them.
1031 exchanges operate on the principle that reinvesting the profit from a property sale does not generate the funds proper to pay any tax. When exchanging for a similarly used (“Like-Kind” property in IRS lingo), the value of the investment does not change, hence no taxable gain. The transaction taxes are deferred until the final sale of the replacement property, thus granting the investor more money to invest in property, like a tax-free federal loan.
Since 1031 exchanges operate within federal regulations to postpone paying taxes, they must adhere to the strict guidelines outlined in the IRS code. Only properties used for commercial purposes or intended solely as investments qualify to be exchanged with tax deferments. Personal residences do not count and vacation homes are only acceptable if they have been rented to tenants for profit for a year or more. If the property is of this commercial type, it may be exchanged for any other “like kind” property. Land, house, multi-family housing structure, office, retail space, warehouse, and any other type of profitable property all may be exchanged for another.
The value of the replacement property must be greater than or equal to the value of the relinquished property. The same holds true for the equity and debt on the replacement property. The sale of the relinquished property must be exchanged for a replacement property and all the proceeds from the sale of the relinquished property must be invested in the replacement.
Investors have 45 days to complete the exchange, during which their proceeds must be held in a safe harbor so the investor (taxpayer) does not have a concrete receipt of the funds that would be eligible for taxation, thus disqualifying the exchange. This safe harbor is referred to as a Qualified Intermediary (QI) who is responsible for moderating the transaction as a neutral party with no blood or personal relationship to the investor. During the 45-day period, the investor must find a suitable “like-kind” replacement property in the value range mentioned in the previous paragraph. There are no extensions, so if the deadline is not met, the investor will have to pay taxes on the relinquished property. The number of properties investor can identify is flexible, however he must stay within at least one of three constraints;
- Investor may identify three or fewer replacement properties
- Investor may identify as many properties as he desires, but their collective value may not exceed 200% of the value of the relinquished property
- Investor may identify as many properties as he wants, but when he actually acquires a property, or properties, the value must be at least 95% of the value of all the identified properties
The investor must choose an acceptable property and complete the purchase within 180 days of selling the relinquished property or the exchange will be compromised.
Boot is another aspect of the 1031 exchange that is strictly regulated. “Boot” refers to any property that is not like-kind that changes hands during the 1031 exchange, most often in the form of cash or mortgages. Usually, the relinquished and replacement properties will not be completely equal in value, so one party may give cash to the other to compensate for the difference. This is called “cash boot,” and the term includes any sales proceeds that the investor does not reinvest in the replacement property, which are both taxable.
If the relinquished property has a mortgage on it, the investor must put a larger mortgage on the replacement property or the monetary discrepancy is called “mortgage boot,” also eligible for taxation. Increasing the mortgage on the replacement property or putting your own money (separate from the exchange) into the property can make up the difference in purchase price, thus nullifying the mortgage boot. All cash boot is taxable, therefore its minimization is preferential.
1031 exchanges are beneficial to the investor as they provide more start-up capital to invest in a property by saving that amount from federal taxation. But remember, taxes are not cancelled, merely postponed until the property is ultimately sold. Or the investor can keep the property until death when taxes no longer apply.
