What is a Tax Deferred Exchange?
A tax deferred exchange is simply a method by which a
property owner trades one property for another without having to pay any
federal income taxes on the transaction. In an ordinary sale
transaction, the property owner is taxed on any gain realized by the
sale of the property. But in an exchange, the tax on the transaction is deferred
until some time in the future, usually when the newly acquired
property is sold
These exchanges are sometimes called "tax free
exchanges" because the exchange transaction itself is not taxed.
Tax deferred exchanges are authorized by Section 1031
of the Internal Revenue Code. The requirement of Section 1031 and other
sections must be carefully met, but when an exchange is done properly,
the tax on the transaction may be deferred.
In an exchange, a property owner simply disposes of
one property and acquires another property, rather than the sale of one
property and the purchase of another.
Today, a sale and a reinvestment in a replacement
property are converted into an exchange by means of an exchange
agreement and the services of a qualified intermediary - a fourth party
who helps to ensure that the exchange is structured properly.
The IRS' new regulations make exchanging easy,
inexpensive and safe.
Internal Revenue Code (IRC) Section 1031 is one of the
last remaining tax loopholes. It is a powerful tool that allows
investors to exchange any investment property for any other investment
property. For your exchange to be valid, you must follow specific IRS
regulations.
Here is an abbreviated list of the regulations.
1.) The properties being exchanged must be of a like
kind. For example, you may exchange:
- a house for another house (or several houses)
- a house for commercial real estate
- land for rental property
- a strip mall for an office building
- any investment property for any other investment
property (as long as it is not occupied as your primary residence)
2.) You must identify and close on your replacement
property within a specific period of time.
- You must identify the property (can identify 3
of them) within 45 days of selling your other home (day of
settlement)
- you may not use ANY of the proceeds from
the sold property or you will negate the exchange
- You must settle on one of the three identified
properties within 180 days from day of settlement (do not
count this by months as some months have 31 days
3.) 100% of the proceeds from your current property
must be held by a Qualified Intermediary and applied toward your
replacement property to get a full tax deferral.
4.) Your replacement property must be of equal or
greater value to the property you have sold to get a full tax deferral.
5.) Properties being exchanged must be used for
investment. Personal residences are not exchangeable.
Why
use a 1031 exchange:
To defer your
capital gains tax
To diversify
- Exchange one
property for a larger one.
- Exchange one
property for several properties.
- Increase
depreciation.
To simplify
- Exchange several
properties for fewer (or one) property.
- Improve the
quality of your property.
- Decrease
management responsibility.
To relocate
- Exchange for a
property closer to where you live.
- Exchange to an
area with higher appreciation.
There is a new
concept where your Roth IRA can buy a vacation property. It is not a
very complicated procedure, but as with all tax exchanges - YOU
MUST FOLLOW THE RULES EXACTLY
Please consult your tax advisor
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