A key tool for long-term real estate investors is found in Section 1031 of the U.S. Tax Code.  It is the taxdeferred exchange, also known called a like-kind or 1031 exchange.  What makes a tax-deferred exchange valuable?  With a tax-deferred exchange, you are able to dispose of a property that has appreciated and re-invest in a property or properties with better investment potential.  You can also re-leverage (spread around your equity) by acquiring two or more other properties.  With either objective, you can put off paying federal taxes on the gains until later.  

With capital gains taxes currently at very low levels, in recent years some investors have chosen, instead, to pay tax on the gains.  Why?  For one thing, they were concerned that gains tax rates may be higher in the future should Congress decide to close the current budget deficit by increasing taxes.  Another reason is that during the last  years of the hot market it was tough to find suitable replacement properties.  Provided that the property has been held for at least a year, gain from the 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 ample replacement properties to be found, we should see a reinvigorated demand for 1031 exchanges, provided the rules stay the same.  With that in mind, let’s review 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 includible on your current year’s tax return.  In the case of real estate, virtually any type of U.S. investment real estate can be exchanged for any other type of U.S. investment real estate.  Personal use property, such as a second or vacation home, does not qualify. 

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 an intermediary.  The seller then has 45 days after the sale of the old property to identify 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 (extension included).  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 www.1031.org, the web site of the Federal of Exchange Accomodators, the professional trade association for intermediaries.  Like-kind exchanges allow investors to re-leverage by exchanging property with a lot of equity for two or three others.  The maximum is generally three of any market value.  However, more are permitted provided they do 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, either to a more promising area for appreciation or to a geographical area that is closer to the investor’s home, for instance, as a convenience in managing the property.  Understand that with a tax-deferred exchange, the tax basis of the new property will be the basis of the old property, which will probably reflect depreciation deductions.  That will also limit the depreciation deductions on the new property.  We do want to emphasize that a tax deferred exchange cannot be used for a vacation or second home whose purpose has been personal use.

This entry was posted on Thursday, August 7th, 2008 at 12:26 pm and is filed under 1) Questions for Loan Officer, 2) General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.