1031 Tax Deferred Exchange Like-Kind Exchange

Posted by Matthew Lahti on Monday, March 4th, 2013 at 12:17am

1031 Tax Deffered Tax Exchange is a Great Option for Investors Looking to Maximize Their Return on Investment

Section 1031 of the Internal Revenue Code needs to be read and understood by every real estate agent and any real estate investor who’s managing his own portfolio of properties. While this might not sound like everyone’s favorite choice of reading material, it’s critical for maximizing the return on an investment. The federal government rewards people who buy real estate and 1031 property exchanges can be a vital component in building wealth.

If an investor follows the rules, the tax on any capital gains realized on the sale of investment real estate can be deferred indefinitely. Section 1031 is complicated, but the most important thing to remember is that the seller can never touch the proceeds of the sale. An intermediary is used to hold the funds in escrow until the money is applied toward the purchase of a similar type of real property. Similar property means investment property and doesn’t include owner-occupied personal residences. It does, however, allow vacant land to be exchanged for improved property and vice versa. One property can be exchanged for multiple properties and multiple properties can be sold to purchase one exchange property. The names on title must be identical for both the relinquished and replacement properties. In order to defer all gains, the replacement property must be of equal or greater value than the relinquished property and all proceeds must be reinvested. There are four basic types of exchanges – simultaneous, delayed, reverse and improvement.

A simultaneous exchange occurs when the closings occur on the same day. Ownership of the relinquished and replacement properties is transferred without any significant interval of time separating the events.

The delayed version of the 1031exchange is a bit more complicated. A seller enters into an exchange agreement with an intermediary and has 45 days after closing to identify in writing one or more suitable replacement properties and 180 days to close on one or more of the identified properties. Multiple replacement properties are permissible as long as one of the following conditions is met: three properties are allowed regardless of the market value, any number of properties are permitted provided the total fair market value doesn’t exceed 200 percent of the total value of the relinquished properties as of the initial sale date, or any number of replacement properties qualify as long as their aggregate value at the time of the exchange is at least 95 percent of the total value of the properties initially identified.

Reverse exchanges are necessary when the investor wants to close on the replacement property before the relinquished one has sold. In this case a third party – usually the intermediary – will take title to the replacement property and this starts the  investor’s countdown for the following restrictions: the investor signs an agreement with the intermediary within 5 days of the closing, identifies the relinquished property within 45 days and completes the exchange of the relinquished property within 180 days.

 An improvement exchange can be accomplished in a variety of ways. The most straightforward is a version of the delayed exchange. The relinquished property is sold and the intermediary holds the proceeds of the sale. A replacement property is identified and title to the property is transferred to the intermediary. The investor makes improvements to the property which increases the fair market value of the property and benefits the investor if the property would not otherwise be of equal or greater value than the relinquished property. The investor finishes the improvements within 180 days and the exchange is completed and title is transferred to the investor.

 Properties can continue to be exchanged until the investor’s death, thereby avoiding payment of any capital gains tax. However, once a participant is sold and not exchanged, the capital gains will be taxable. Contact an accountant for additional information.

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