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The §1031 tax deferred rehabilitation of capital gains is one of the most enthralling real estate investor vehicles for preserving and construction real estate wealth: This provision of the tax code allows asset owners to change their asset for other like-kind asset without recognition of capital gains.
The capital gain and tax liability are both transferred ("deferred") from the "old" asset into the "new" one, so there are not tax consequences or liability to the seller at the time of the sale of the "old" property.
The beginning
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The idea of exchanging properties to avoid ("defer") tax is not new. 1031 change reformed discrepancy of Two and Multi-party exchange.
First; Two-party exchange
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Direct change (i.e., a swap), or the "your property" for "my property" is called a two-party exchange. Here there are two asset owners who each want the other's property. When this rare situation occurs, the parties change properties and avoid ("defer") tax liabilities. The main problem here is that rarely there will be two asset owners who each want the other's property.
Then; Multi-party exchange
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The three-way or multi-party change technique was designed to solve the dilemma of a two-way swap. The big problem here is that if one or more of the parties would not cooperate with the exchange, the whole change failed like a "Domino Effect".
Now; 1031 Exchange
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By permitting you to "sell" your Relinquished ("old") asset now and use the proceeds to buy the change ("new") asset later 1031 change eliminate the need of finding someone else real estate owner who agrees to change properties (instead of selling) to avoid tax liability.
Exchange Requirements
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Overview
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There are three conditions that must be met to achieve non-recognition of gain under §1031:
1. The properties exchanged must qualify, and be of "like-kind".
2. There must be an actual exchange, not a change of asset for money only.
3. The time requirements must be strictly followed.
Qualify, "like-kind"
To qualify as a like-kind exchange, the asset must be both (1) qualifying asset and (2) like-kind property.
What is a qualify property?
For income tax purposes, real estate is divided into four categories made as of the date the transaction:
1. Held for business use (§1231) - asset used in normal policy of business or rental property; Qualify
2. Held for venture (§1221) - asset purchased and sold for generating capital gain; Qualify
3. Held for personal use - vacation home, second home; Does not Qualify
4. Held primarily for sale (dealer property) - resale or inventory; Does not Qualify
The first two classifications "held for business" and "held for investment" qualify for §1031 rehabilitation while the second two "held for personal use" and "dealer property-do not".
What if a asset falls under two categories?
For example what if a asset held for investments partially used for personal use? The sale will be allocated between the two categories based on the part of each one.
The change Process
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The following is a reveal of the process and timeline:
Sale of Relinquished ("old") Property
To trigger the tax deferred transaction, you must sell your property.
Identification the change ("new") Property
You have 45 days from the day you sell the "old" asset to recognize the change ("new").
Replacement asset is identified only if it is designated as one in a written document signed by you. This document must be hand delivered, mailed, faxed or otherwise sent before the end of the identification period to a someone (other than yourself or a associated party) involved in the exchange. The document must include unambiguous legal report or road address of the property.
Number of change Properties that can be identified
You may recognize more than one asset as change asset subject to three rules:
3-Property Rule:
The maximum amount of change properties you may recognize is three properties regardless of their fair market values.
The 200 Percent Rule:
There is no limit on the amount of properties you recognize as long as their total fair market value does not exceed 200 percent of the total fair market value of all Relinquished Properties.
The 95 Percent Rule:
There is no limit on the amount of properties you recognize as long as during the change period you honestly received identified change Properties having a fair market value equal to or more than 95 percent of the total fair market value of all identified change Properties.
Value of change ("New") Property
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The value of the change asset must be equal to, or greater than, the adjusted sales price of the Relinquished Property.
All proceeds from the Relinquished asset sale need to be invested in the change Property.
Sale Proceeds Go To powerful Intermediary
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Section 1031 requires an actual change of properties. If you plainly sell your asset and reinvest the money in someone else property, you will not qualify for change treatment, even though it is a simultaneous close.
A powerful Intermediary is a someone (or company) who, for a fee, acts to facilitate the deferred change by entering into an trade with you for the change of properties.
The powerful Intermediary does not contribute legal or exact tax advice to the exchanger, but will normally achieve the following services:
1. Coordinate with the exchangers and their advisors, to buildings a victorious exchange.
2. Prepare the documentation for the Relinquished asset and the change Property.
3. Furnish escrow with instructions to corollary the exchange.
4. Secure the funds in an insured bank account until the change is completed.
5. Provide documents to change change asset to the exchanger, and disburse change proceeds to escrow.
Receipt of change Property
You have 180 days from the day you sell the "old" asset to receive the change ("new").
Replacement asset is treated as received before the end of the change period if:
1. You honestly acquired the change asset (close the transaction) prior to the end of the change period (180 days, or the due date of the taxpayers tax return, whichever is earlier), and
2. The change asset acquired is substantially the same as identified during the 45- day identification period.
Boot and assessable Gain
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Money and unlike asset in an change is called boot.
If, in expanding to the change Property, you receive money or some other kind of boot, you may have assessable gain. The tax is due only on gain that comes from the money and other boot received.
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