It’s something savvy real estate investors have known about for years. Now we’re letting you in on the not-so-closely guarded secret. Under Section 1031 of the Federal Tax Code, people can defer payment of capital gains taxes on the sale of a property that has appreciated, as long as they reinvest the proceeds in another property. However, there’s a catch – to take advantage of this opportunity without running afoul of the IRS, you must play by the rules – and there are quite a few. Here’s what you need to know to stay out of trouble:
First of all, as IRC Section 1031 (a)(1) stipulates: “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
In other words, you can sell a property that has appreciated and use the money to buy more real estate as long as the new property is kept for business use or as an investment. Or, to put it another way, if you own a commercial garage that you lease to a mechanic or body shop, you can sell it and use the money to buy an empty lot where you want to build something else. On the other hand, if you are a mechanic who leases the commercial garage and you want to retire, sell your business and use the money to buy a house in the country, you can’t do a 1031 exchange because you don’t own the property.
Here are some other things to keep in mind regarding purchases and sales in 1031 exchanges. You can’t use your primary residence in a 1031 exchange, and all properties involved in a 1031 exchange must be located in the United States. Finally, as a taxpayer, you can sell a property to a related party in a 1031 exchange but the transaction is subject to a two-year holding period. And as a taxpayer, you cannot buy property from a related party in a 1031 exchange.
Another important rule pertains to the deadline for identifying the new property once the sale of the old property is finalized. Once the first part of the transaction in a 1031 is legally concluded, you have 45 calendar days to find a new property to buy. If you haven’t entered into a contract on a new property within the specified time, you must still provide a detailed list of the properties you are interested in before the deadline expires. While there are no limits on the number of properties you can identify within the 45-day window, there is a limit on the total value of the new properties if you choose more than three. Specifically, it cannot equal or exceed twice the value of the property you sold.
In addition to the deadline for finding the new property/properties, there is a deadline for closing on it (or them). As stipulated in Section 1031, you have roughly six months (180 days) to purchase and close on one or more of the new properties after the closing of the old one. Because the 45-day deadline for identification and the 180-day deadline for closing on the new property/properties run simultaneously, the actual window for closing on the new property can be limited to 135 days. In any case, the subject of the transaction must be one or more of the properties included on the 45-day identification list.
Here are some more rules to keep in mind:
• You cannot handle the transaction yourself
• The person or entity who held title on the property that was sold must also hold title on the new property/properties
• To delay full payment of the capital gains tax on the old property, the new property must be worth at least as much or more than the old one.
Clearly, this is a valuable tool for investors. But as we have seen, it is also a complicated process. If you’re a real estate investor, business owner, or just a savvy real estate buyer, contact us today to find out how Loshak Leach LLP can help you complete a 1031 exchange today!