1031 Exchange Lowdown

Investing in Real Estate? Check The Tax Rules

How many of you know about this law that closes certain loopholes in Section 1031 and Section 121, which was signed in by President Bush in 2004. Some of you do, but there are quite a few who are still unaware of this new rule. Well, let’s get the basics right first: Section 1031 allows you to defer capital gains from a property sale by rolling the proceeds into another investment, trade, or business property of equal or greater value.

Section 121 deals with property used for residential purposes and allows, under certain circumstances, tax-free profits on income gained from the sale of property. You should have used the property as a principal residence for two or more of the past five years to qualify for this benefit.

Now if you were to use section 1031 and section 121, you’d get a double benefit. Now, here’s where the twist in the tale unfolds.

The taxpayer must now hold the property for five years, use it as an investment property for a portion of the five years, and use it as a personal residence for at least two years before selling it, in order to avoid capital gains taxes. The newness of the amendment--and the lack of fanfare with which it became law--may catch taxpayers off guard.

If you want to know more about this amendment, read on.

How Long Is Long Enough?

By Priya Jestin, Staff Writer

This is one of the most oft-asked questions when investors want to benefit from a 1031 exchange sale. You’ve got some property you want to put on the market. You want to take advantage of the benefits offered by a like-kind 1031 exchange. Realize that while it is a potentially beneficial tax arrangement, it is quite complex and you must check regularly to ensure that you are following the rule of the law.

For instance, if you do a proper exchange, you do not have to pay capital gains tax on the property that you have sold, known as the "relinquished property." Instead, the tax basis of your former property becomes the tax basis of a new property, known as the "replacement property."

Converting your replacement property from rental to principal residence is one such minefield. Assume you purchased an apartment in a 1031 exchange. Now, in a 1031 exchange, it is important that both the relinquished property and the replacement property be held for investment purposes. So you rent out your apartment.

If your final aim is to convert the apartment into your principal residence, it is important for you to know when you can safely convert it without attracting IRS attention. The problem is that nobody has an exact answer. Most tax lawyers say that you have to keep it as investment property for at least one full year. However, you’d do better to follow the IRS’ ‘old and cold’ rule. This only means that if the property has been held as an investment for two years, the IRS will not challenge the facts.

.cIntricacies In The Sale Of Vacation Homes

By Priya Jestin, Staff Writer

Most Americans with spare resources usually invest in a vacation home. It could be a condo in Florida or a cottage on Cape Cod. Whatever the case, if and when they decide to sell their vacation homes, most people are a bit confused and not too sure if the provisions of Section 1031 will help them save taxes.

If you have been using your vacation home for personal use more than incidentally you may have a problem on your hands. You could be hard pressed to qualify the same as investment property eligible for like kind exchange treatment. That does not mean you cannot avail of the tax benefits – all you require is some planning. Remember three things:

• You should not use your vacation home for personal use for more than 14 days, or 10% of the number of days during the year of the sale.
• The property should be rented at fair market rent during the year of the sale (or at least listed for rental). There is no fixed length of time for which the residence must be rented out – often one year is recommended but there is no direct authority for this.
• If you have used the vacation home significantly during the past year, you could consider converting it to your principal residence. This will help you qualify the residence for the gain exclusion under Section121.

There’s one thing you need to remember: If you acquired the vacation home in a like-kind exchange, however, the exclusion that applies to gain realized on the sale/ exchange of a principal residence under Section 121 does not apply. This is only true if you sell/ exchange the vacation home during the five-year period beginning with the date on which you acquired your vacation home.

I know understanding all these intricacies takes time. The best thing for you to do if you are still in doubt is to contact a tax professional. The professional will be able to analyze and correctly guide you through the sale of your vacation home.

Learn How To Keep The Taxman At Bay

By Priya Jestin, Staff Writer

Old age is a time for reflection and not to work yourself to death trying to save taxes. But that is if the taxmen allow you to do so. Often they are busy holding you by the scruff of your neck and trying to wheedle out every last bit of money. While this is exaggeration, I don’t think I’m widely off the mark when I say that like me, you too don’t like the taxman too much. Well so, if you want to avoid the gaze of a taxman when you plan to get yourself a retirement home, there is an easy way out.

And don’t worry, it is perfectly legal. You just have to indulge in some good old barter. Confused? Well, at the end of the day, isn’t 1031 exchange a form of barter where you exchange one property for another? The only difference is that you end up deferring your capital-gains taxes on the property you’ve given up. But you must follow the IRS's strict rules and establish that your original intention was to use the new property for investment, not as your residence. That's why having a tenant with a lease is a good idea.

The Value Of A 1031 Exchange

Are you wondering if structuring the sale and purchase of investment property, as a 1031 exchange is the right thing to do to improve your bottom line? You are not alone, there are quite a few people who are still to fully comprehend the nitty-gritties of 1031 exchanges. Transunionexchange.com reports:

Let's assume that a taxpayer acquired a 10-unit apartment complex a number of years ago for $500,000. The current fair market value is $1,000,000 and the annual net cash flow after expenses and debt service is $25,000. The taxpayer could significantly increase his or her cash-on-cash rate of return by selling this apartment complex and reinvesting in a more profitable replacement property with no income tax consequences by completing a 1031 tax-deferred exchange.

Read more: Is Doing a 1031 Exchange Worth It?

Receipt of Funds Can Make You Lose Benefits

By Priya Jestin, Staff Writer

Quite a few people have asked about the need for a qualified intermediary in a 1031 exchange. While we have looked at the role of the qualified intermediary in detain in the recent past, let’s take a look at this role in the context of the receipt of the exchange funds.

During a normal sale or purchase of property, you need not be worried about what you do with the funds. However, in a 1031 exchange, you need to be extremely careful during the exchange period. While the process is in progress, you are not allowed to have any actual or constructive receipt of the exchange funds.

You are considered to have actual or constructive receipt of the exchange funds when you have actual possession of the funds or receive any economic benefit from the funds or assets. If you receive any portion of the exchange funds or assets during the exchange period, you could end up not only paying taxes on that amount but your 1031 exchange transaction may also be disallowed.

There is only one way to avoid this – assign a Qualified Intermediary into the purchase and sale agreements of the relinquished property and the replacement property. You must do this before either transaction closes and the properties are transferred to the respective buyers. If you close either transaction before getting a Qualified Intermediary assigned into the transaction, the transaction will fail to qualify as a tax-deferred like-kind exchange.

How To Defer 100% Taxes

We can defer some of the tax when we use a 1031 exchange. But to qualify for a 100% deferment of taxes, an investor must spend all of the net equity from the sale on the purchase of replacement property and acquire property with equal or greater debt on it as the relinquished property had prior to sale. Findarticles.com reports:

One exception to this rule is that investors can always replace any debt reduction with additional cash. Net equity is defined as equity less mortgage debt and exchange expenses. Exchange expenses do not include all closing costs however. Exchange expenses are defined as those expenses one typically incurs in connection with the purchase and sale of real estate.

Read more: Commonly asked questions about 1031—Part 2

Pass On Your Legacy, Not Taxes

--By Priya Jestin, Staff Writer

Being able to own real estate is a dream for many people. Of course you do have your 5-bedroom home, but aren’t you bogged down by mortgages and home equity loans? Well, imagine being able to really own your home/ property and then pass it on to your heirs as inheritance. So how do you pass on this inheritance without the pain of taxation?

I know you probably think I don’t know what I’m talking about. Well, how about using this strategy. Try having your real estate deeded into a family partnership or a limited liability company. Once you’ve done that, you can continue to take management income from the property. And what’s better, your heirs will receive the property without taxation. How does this happen? With a 1031 exchange of course! And your heirs can continue to 1031 exchange the property and grow a real estate portfolio.

Basically, what a 1031 exchange does is help you shelter the gain of a sale and defer all state and federal taxes. This helps you unlock the biggest impediment to a high rate of return: excess equity. So, before you pass on your real estate to your family, you need to grow it. For this all you need is to begin with a property sale and use the provisions of 1031 exchange to save the capital gains tax on your property. You can use this money for investment in a replacement property.

Once you purchase a new property as per 1031 exchange rules, you can refinance your replacement property and take out cash as loan proceeds. This means you get access to the equity in your property by refinancing it and don’t have to pay capital gains tax. All you need to remember is that before you play this game, you MUST learn the rules and never flout them.

Combine Sale, Double Benefits

--By Priya Jestin, Staff Writer

I had written recently about how homeowners can apply both IRC 121 and IRC 1031 capital gain exclusions to the sale or exchange of a home. This helps you double your savings. However, to reap these benefits, it’s very important that you qualify for and comply with all the rules in BOTH the sections. The property or portion of the property:

1 should have been used in your trade or business or been held for investment purposes within the guidelines set forth by IRC §1031

2 should have been the taxpayer’s principal residence as required under §121.

Remember, depreciation taken on a principal residence is eligible for deferral under Section 1031. You can check IRS’ web page for examples on the treatment of depreciation and boot.

Know Permissible Settlement Costs

Quite a few people believe that the proceeds you earn from a tax-deferred like-kind exchange cannot be used for many things. Fact is these proceeds can be used to pay for certain routine permissible transaction, or settlement and closing costs related to the disposition of the relinquished property. It can also be used to acquire the like-kind replacement property without creating an income tax liability for you, the investor.

While you can pay other expenses , financing costs and settlement charges with these proceeds, it may be a costly proposition. These expenses will be considered to be cash boot received by the investor. This may therefore result in an income tax liability (non-permissible expenses and closing costs). In certain situations, cash boot paid can be offset by cash boot received and will reduce the Investor's income tax liability. Exeterco.com reports:

Investors should therefore always review their estimated settlement statement and/or HUD-1 statement with their tax and/or legal advisers prior to approving the estimated expenses and closing costs to ensure they have a complete understanding of the income tax consequences from the transaction prior to the closing of the transaction.

Read more: 1031 Exchange Permissible and Non-Permissible Closing/Settlement Costs