Tax deferred exchange | 1031 MD DC VA
A key tool for long-term real estate investors is the tax-deferred exchange, also known called a like-kind or (IRS Code Sec.) 1031 exchange. What does a tax-deferred exchange do do? It allows you to sell an appreciated investment property and reinvest in property, while postponing payment of federal taxes on any gains.
A tax-deferred exchange allows you to dispose of a property that has appreciated and reinvest in property or properties with greater investment potential. You can also use it to releverage (spread around your equity) by acquiring two or more other properties. With capital gains taxes currently very low, some investors have chosen to pay tax on the gains. That option will be less attractive if Congress raises capital gains tax rates to cut the budget deficit. Another reason to take gains is if it is difficult to find suitable replacement properties. That is certainly less the case today, with relatively high inventory levels of homes in many markets.
Provided that the property has been held for at least a year, gain from a sale is taxed at capital gains rates, generally 15%. However, to the extent depreciation has been taken, which most real estate investors will have done, gains are taxed at a maximum rate of 25%. With that in mind, let’s examine how a tax-deferred exchange works. The rules provide that gains realized on the exchange of property that has been held for productive use in a trade or business, or for investment, for other “like-kind” property is deferred. That means the gain is not included on your current year’s tax return.
In practice, deferred exchanges of residential rental properties typically are three-step transactions. The property being disposed of (the “relinquished property”) is sold to a second party, with the sale proceeds held by a “qualified intermediary.” The seller then has 45 days after the sale of the old property to “identify” (contract for) a new property or properties. The acquisition must take place at the earlier of 180 days from the settlement date or the due date for the federal income tax return from the year in which the property is sold (including any extension).
The “replacement property” can also be bought in advance of selling the old property and special rules apply to such “reverse exchanges.” In any case, the replacement property must be specifically identified in exchange documents. It is essential that a qualified intermediary be used to facilitate the transaction. Your Realtor can probably assist in finding one or refer to 1031.org, the web site of the Federation of Exchange Accomodators, the professional trade association for intermediaries.
Like-kind exchanges allow investors to releverage by exchanging property with a lot of equity for two or three others. The maximum is generally three properties of any market value. However, more properties are permitted provided the total value does not exceed 200% of the aggregate market value of all the relinquished properties. Exchanges also present an opportunity for an investor to shift the location of investment properties. It could be to a more promising area for appreciation or to an area closer to the investor’s home, to make it easier to manage the property.
With a tax-deferred exchange, the tax basis of the new property will include the basis of the old property, which will probably reflect depreciation deductions. That will limit the depreciation deductions on the new property. A tax-deferred exchange cannot be used for a vacation or second home whose purpose has been personal use. However, a second home can be converted to a rental. Once its business and investment credentials have been established (one year as a rental property should suffice), it can then qualify for an exchange. © 2009, Real Estate Information Services, Capitol Assets, Choice Real Estate, Inc.