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1031 Exchange of Like Kind
Property - Tax Deferred
Exchange of Property
Avoid paying taxes when you
sell your rental property via
the Starker 1031 Exchange. Learn the rules, steps, and time
frame to use this benefit given to your by the IRS
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Nontaxable Exchanges
Certain exchanges of property are not taxable.
This means any gain from
the exchange is not recognized, and any loss cannot be deducted. Your
gain or loss will not be recognized until you sell or otherwise dispose of
the
property you receive.
Like-Kind Exchanges
Internal Revenue Code 1031 (commonly
known as "like-kind
exchange") is one method a taxpayer may use to defer their tax
bill. The like-kind exchange applies to property held for
investment only. A personal residence does not qualify
for
the like-kind exchange.
There are many names for these exchanges, including: 1031
exchange, Starker exchange, tax-free exchange, tax-deferred
exchange, trading properties, delayed exchange, like-kind
exchange, etc...
The nature of this transaction is a "deferred exchange". What
this means is that you transfer your real estate investment property to
another real estate property which you will hold for investment.
Like-Kind Exchange Requirements
To be a like-kind exchange, the property traded and
the property
received must be of the following:
- Qualifying property -
Both the property you give up and
the property you receive must be held by you for
investment or for productive use in your trade or business.
- Like-kind property -
These are properties of the same
nature and character, even if they differ in quality. The
exchange
of a rental property for another rental property is an exchange
of like-kind property.
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If the exchange of like-kind property
involves the receipt of money
or unlike property or the assumption of your liabilities, you may
have to recognize the gain.
1031 Like-Kind Exchange Steps
The 1031 like-kind exchange is generally accomplished with little
effort on the part of the buyers and sellers. The steps are as
follows:
- List your property for sale
with your real estate agent.
- When you get an offer, your
agent will include a counteroffer
provision that states the "buyer agrees to cooperate with
seller's 1031 exchange.
- Open escrow and choose your
accommodator or
qualified intermediary; these are the facilitators of the
exchange process who hold the proceeds from the sale of
the relinquished property until the purchase of the
replacement property is ready to close. Your real estate
agent can help you choose or recommend an qualified
accommodator. Be careful who holds your money. And
especially be careful in choosing someone over the
Internet.
- Sign and exchange agreement
with your accommodator
through escrow along with other paperwork.
- At the close of escrow, your
proceeds will be transferred to
your accommodator's trust fund on your behalf and held
there until you begin the process of buying your
replacement property.
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Equal or Higher Price
To defer all capital gain
taxes on the sale of a property through the
1031 like-kind exchange, the replacement property must have a
price equal to or higher than the relinquished property. For
example, if you had a property that you sold for $180,000, the value
of your replacement property must be at least $180,000. You can
still make a like-kind exchange if the property is less than $180,000,
but you will have to pay taxes on the difference.
The basis of the property received in the like-kind exchange is
the same as the basis of the property you transferred. For
example, Skip exchanged real estate held for investment with an
adjusted basis of $150,000 to another real estate investment. The
fair market value of the new property is $315,000. The basis for his
new property is the same as the basis of the old, $150,000.
Depreciation you may have taken out on your rental properties
also affect the basis of the newly acquired property.
Example: You originally purchase a rental house for $150,000
and you have accumulated depreciation of $80,000. This means
that the basis in your property is $70,000 ($150,000 - $80,000).
Let's assume you sell it and do a like-kind exchange for another
rental house that has a fair market value of $250,000. The adjusted
basis would transfer and represent the first $150,000 of the
replacement property. Thus, the beginning basis on the
replacement property after the exchange would be $170,000
($70,000 base of the relinquished property and the $100,000
additional amount paid to get the $250,000 purchase price).
Time Limits
You must identify the property to be received within
45 days after
the date you transfer the property given up in the exchange. This
period is called the "identification period". Any property received
during the identification period is considered to have been
identified. Thus is a very strict rule. There are no extensions
because of holidays, illness, or anything else.
Your replacement property must be received within 180 days of
the closing and transfer of the relinquished property or the due
date for the transferor's tax return for the taxable year in
which the transfer of property took place. It is critical that
you understand this timing rule, as the example below shows.
Example: Tony begins to make his 1031 like-kind exchange on
December 20, 2007 when the property he was selling closed
escrow. By early April 2008 Tony has identified his replacement
property and escrow will close at the end of the month. On April 14,
Tony files his taxes. It's clear to see that Tony is well within the
180
day time limit. He will NOT be eligible for the like-kind
exchange
however. The reason is that he filed his income taxes on time.
The rule clearly states that the replacement property must be
received within 180 days or the due date of the tax return for the
taxable year in which the transfer of property took place. Tony
could have filed an extension for his income tax returns and waited
to file until after the replacement property had been received.
As with the above time limit, there are no extensions for
the 180 day time limit.
"Boot"
When you use the like-kind exchange, anything your
receive which
is not like-kind property is considered "boot". Boot is fully taxable.
There are two types of boot that you need to understand:
- Cash boot - Say you exchange a
property worth $225,000
with no mortgage for for a property worth $200,000 with no
mortgage, you would receive $25,000 in cash. Cash is not
"like-kind" to real estate. Thus, the $25,000 is considered
boot and is taxable.
- Net debt relief - Say you
exchange a property worth
$310,000 with a mortgage of $100,000 for another property
worth $$290,000 with a mortgage of $80,000, you will receive
no cash. But, your debt has been reduced by $20,000.
This debt reduction is boot and is taxable.
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Alternative and Multiple Replacement
Properties
You can identify more than one replacement property.
Regardless of the
number of properties you give up, the maximum number of replacement
properties you can identify is the larger of the following:
- Three
- Any number of properties whose total fair market value (FMV)
at the
end of the identification period is not more than double the
total
fair market value, on the date of the transfer, of all the
properties
you give up.
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Losses
If you have a loss on a like-kind exchange, the loss
is NOT deductible.
Foreign Real Property Exchanges
Real property located in the United States and real
property located outside
of the United States are not considered like-kind property under the
like-kind
exchange rules. If you exchange foreign real property for property
located in
the United States, your gain or loss on the exchange is recognized by the
IRS.
Like-Kind Exchanges Between Related Persons
Relatives are allowed to exchange investment real
estate, if they meet the
IRS criteria above, and defer taxes in the process. If either party,
however,
disposes of the property within 2 years after the exchange, the tax free
exchange is
disqualified.
The exception to this is if one of the people
involved in the exchange of real
estate dies.
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