Trade Properties To Keep The Taxman At Bay

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Trade Properties To Keep The Taxman At Bay

The fundamental idea of a “like-kind exchange” is one that you are already acquainted with if you ever exchanged baseball cards with a pal when you were a child. Perhaps you had a sneaking sense that José Canseco’s career wouldn’t turn out well but your friend truly adored him and wanted your Canseco rookie card. You two decided to trade Canseco for some of his promising prospect cards. You assessed the worth of your card, chose which of his cards you wanted in exchange, and then made the trade. It’s likely that the IRS didn’t get a share of the profits.

Real estate investors may accomplish a similar task by delaying capital gains or losses when they acquire or sell a property by using a like-kind exchange, commonly known as a section 1031 exchange. Basically, a like-kind exchange lets you trade investment properties with another investor while keeping the IRS out of the picture until the property is finally sold for cash, which happens much later. Although the procedure isn’t nearly as simple as exchanging a few baseball cards, this article will walk you through the steps.

Reasons to Take into Account an Exchange A 1031 exchange, which gets its name from Internal Revenue Code Section 1031, gives investors the chance to postpone paying taxes while rebalancing their real estate holdings and using money they would have otherwise paid in taxes for more advantageous purposes. In real estate, unlike individual stocks and bonds, one property may account for a considerable chunk of the value of a portfolio, therefore the capacity to rebalance is crucial.

Because real estate investments are so concentrated, it’s crucial for portfolio managers to have the freedom to rebalance their holdings and place tactical bets in other investment sectors or geographic locations. By enabling investors to switch between real estate exposures by exchanging one property for another without having to pay capital gains taxes right away, a 1031 exchange promotes this rebalancing. Investors can postpone paying capital gains tax until it’s time to liquidate some or all of the portfolio, there is a beneficial change in the tax law, or they have accumulated enough capital losses to offset the capital gain obligation by consistently using 1031 exchanges when buying and selling property. (See Smart Real Estate Transactions for additional information on how to make Section 1031 work for you.)

Overview Investors must abide by certain standards and restrictions on the kinds of properties they may exchange, the locations of the properties, and the timing of some important events in order to be eligible for this tax treatment. Firstly, it’s vital to know that a main property does not qualify, so regrettably you won’t be able to switch from your suburban condo to a beach house in Malibu. The numerous conditions are described in depth in the following section. (For additional information on selling a residential property, see Are You Going to Get Tax Shock When You Sell Your Home? and Is it accurate to say you may sell your home without having to pay capital gains tax?

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The job of coordinating the essential components might be somewhat difficult. Investors are required to engage a third-party clearing house known as a “qualified intermediary (QI)”, which manages all the monies associated to the purchase, sale, and exchange of properties, to assist smooth the necessary transactions and paperwork. The investor has effectively rolled the capital gains into the exchanged properties and may delay the capital gains tax until the sale of real property assets for cash because money does not pass directly through the taxpayer’s accounts and the taxpayer never has control of any of the cash generated by the transaction.

A 1031 exchange’s planning, execution, and associated tax treatment are all fairly intricate processes. A succinct and simplified explanation of the conditions and procedures needed to carry out a 1031 exchange will be provided in the next section.

Transaction Conditions Suitable Elements Only commercial or investment properties are eligible for the exchange. An investment property is one that is bought with the intention of renting it out and earning money. A piece of property that a company owns, uses, and records as an asset on the balance sheet is known as business property. Whether developed or unimproved, all real estate in the United States is often of a similar kind. Real estate located outside of the US is regarded as “not like-kind” property. Exchanges of goods, stocks, bonds, notes, other securities, or any other kind of personal property are not covered by Section 1031. (View our course Exploring Real Estate Investments and Investing In Real Estate for a summary of the many forms of property.)

Assets that do not qualify and the boot The investor must recognize the gain on the sale and pay taxes in accordance if the transaction contains non-qualifying assets (i.e., property or cash that is not of like-kind). The non-qualifying assets used to balance the value between the exchanges are referred to as “boot,” and they are still liable to standard capital gains taxes in the event that the value of one of the traded properties is higher than the value of the other.

Timing While simultaneous transactions are not required, there are several limitations on specific transaction timing aspects. An investor must choose the property to be swapped before closing and choose the replacement property within 45 days of finalizing the sale of the first asset, for instance, in order for the transaction to qualify as a 1031 exchange. In addition, the sale of the original property must be completed within 180 days after the acquisition of the replacement property. Finding replacement assets within 45 days after selling the surrendered item is one of the most challenging jobs for most investors. But because of how rigorous these deadlines are and the IRS’s refusal to allow extensions, it is crucial that they comply.

Qualified IntermediaryThe investors supporting the exchange must work with a qualified intermediary to make the transaction possible due to the intricacy of these arrangements as well as the rules and regulations that surround the exchange. The qualified intermediary, which is referred to as a company engaged only in conducting 1031 exchanges, does not provide tax or legal advice. It cannot be a business party that has any connection to the taxable party during the previous 24 months of the initial property transaction, such as a CPA company, lawyer, or real estate agent. The QI should preferably be a third-party company that has never before offered any of these services to any transaction participants.

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The QI provides a variety of facilitation services and serves as a liaison between the parties to assist plan and carry out the exchange. Its obligations include:

  • Preparing all the required documentation and acting as a clearing house to assure that all appropriate parties receive documentation.
  • Ensuring that funds are held in a secured and insured bank account, and that any disbursements are made to escrow accounts when the transactions are completed.
  • Submitting a full accounting of the transactions for taxpayer records, and providing a Form 1099 to the taxpayers and to the IRS documenting any required taxes and any capital gains taxes paid.

The relevance of the qualified intermediary and the significance of selecting an acceptable one are underlined by the IRS’s tough guidelines surrounding specific prerequisites. It is crucial that investors carefully consider and choose their transaction’s intermediary because one of the QI’s main services is to keep transaction participants on track and make sure they comply with the requirements necessary for taxpayers to qualify for preferential tax treatment of their real estate profits. (See The Benefits Of Using A Real Estate Attorney for further reading.)

The fundamental timeline that investors must follow will be discussed in the section that follows.

Exchanges of many properties An investor is not needed to trade identical properties in a like-kind transaction. As long as the following conditions are satisfied, each side of the exchange may employ several characteristics. Common names for these guidelines include the “three property,” “95%,” and “200%” norms.

  • The three-property rule – Any three properties may qualify regardless of market value.
  • The 95% rule – Any number of properties may qualify as long as the fair market value (FMV) of the properties received by the end of the exchange period is no more than 95% of the cumulative FMV of all the potential replacement properties identified.
  • The 200% rule states that any number of properties may be swapped as long as the total FMV of the replacement properties at the original transfer date is not more than 200% of the total FMV of all the exchanged properties.

The IRS is highly strict about the deadlines for identifying these properties and carrying out the exchange, despite the fact that it is relatively lenient on the quantity of assets it will let to be exchanged in order to help with the deferral of capital gains tax.

Transaction Timeline and Plan Even though the timetable and transaction plan for a 1031 exchange may become quite complicated, several elements have a standard structure and apply to the majority of transactions.

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  1. The first step in a like-kind exchange is for an investor to identify the property or properties to be sold (the “relinquished property”) and then sell them to a third party with the intermediary’s assistance. The middleman gets the money from the seller and puts it all in escrow.
  2. The investor has 45 days from the time the money is placed in escrow to choose one or more “replacement properties” for the exchange; these properties must be acquired from a third party seller within 180 days of the initial transaction. The middleman serves as the buyer, puts the money in escrow, and then transfers the money to the seller or sellers. (To find a substitute, see Find Fortune In Commercial Real Estate and Top 10 Features Of A Profitable Rental Property.)
  3. The QI then generates for the taxpayer all the accounting records necessary to demonstrate that money has passed through a QI clearing house but has not yet reached the investor’s or taxpayer’s accounts. Additionally, the QI creates a Form 1099, sends it to the IRS, and notes any capital gains from the creation of non-qualifying “boot” as well as any taxes that were paid in connection with the transaction.
  4. At some point, the taxpayer will submit IRS Form 8824 to the IRS along with any other documents of a same kind required by the state where the properties are situated or where the taxpayer lives. The competent intermediary will also generate all exchange papers necessary for the transactions, such as property deeds and real estate contracts, in addition to enabling the exchange.

Capital gains are delayed since the QI was in charge of the money used for both the swapped assets’ acquisition and sale, and because the investor got property instead of money when the surrendered asset was sold. Capital gains may be constantly postponed via like-kind swaps until assets are finally sold for cash, with the exception of any “boot.” The accrued capital gains will thereafter be subject to the then-current tax laws.

Conclusion While trading investment assets via a like-kind exchange may not be as simple as trading baseball cards in your childhood, it does allow you to avoid paying taxes in the process. Investors may conduct real property transfers to grow or reduce exposures to certain property sectors while simultaneously deferring capital gains until the properties are finally sold for cash by repeatedly engaging in these like-kind transactions. This is a terrific approach to effectively rebalance your real estate portfolio after you grasp the game’s rules.

Read Tax Tips For The Individual Investor and Money Savings Year-End Tax Tips for further ways to avoid paying taxes on time.

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