While only a small percentage of real estate transactions are done using a 1031 Exchange, this instrument provides for an excellent tax deferral solution.
This blog would not have been possible without the expert advice of Julie Tumbaga at the Honolulu office of Old Republic Exchange Company.
The Internal Revenue Code provides that a taxpayer may sell an asset (personal property or real property) and defer payment of capital gains tax, if that taxpayer uses the proceeds to acquire a like-kind replacement asset.
IRC §1031 provides that neither gain nor loss is recognized if property held for investment or for productive use in a trade or business is exchanged for property held for investment or for productive use in a trade or business.
Four methods of exchanging real property:
There are four methods: simultaneous exchange, delayed exchange, reverse exchange and construction/improvement exchange.
- The Delayed Exchange – A delayed exchange results when there is a delay between the sale of the relinquished property and the purchase of the replacement property. The exchanger must identify a replacement property within 45 calendar days after the close of the relinquished property. The delayed exchange provides investors up to 180 days to purchase a replacement property after the relinquished property is sold. The 45 days is included in the 180 days.
There are a couple of ways to identify properties in an exchange:
a. 3-PROPERTY RULE: Three properties, no matter what the fair market value; or
b. 200-PERCENT RULE: Any number of properties, as long as the aggregate fair market value does not exceed 200% (double) of the fair market value of all the relinquished properties
- The Reverse Exchange – A reverse exchange results when the replacement property is acquired prior to the sale of the relinquished property.
- The Simultaneous Exchange – A simultaneous exchange occurs when the relinquished and replacement properties close at the same time. The use, however, of a Qualified Intermediary, is still required and assures the exchanger that he does not have constructive receipt of his funds, thus ensuring the preservation of safe harbor treatment under the Treasury Regulations.
- The Improvement Exchange – An improvement, construction or build-to-suit exchange occurs when the exchanger wishes to use exchange proceeds to make capital improvements to the replacement property.
Additional things to consider:
- If the property was used as both a principal residence and for investment/rental purposes, you may be able to take advantage of The Internal Revenue Code IRC §121 and IRC §1031.
- A foreign person that sells or exchanges a U.S. real property interest is subject to a required withholding under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). While a foreign person can take advantage of a 1031 Exchange it is important for foreign sellers who have applied for an exemption to recognize that using proceeds to pay the FIRPTA has a taxable consequence because FIRPTA is not considered a necessary expense of sale. There is a solution to this situation and the seller should best discuss at the very beginning of the transaction with their exchange facilitator.
Benefits of a 1031 Exchange:
- Replace non-income producing property with income producing property;
- Diversify property interests for estate planning purposes;
- Replace time-consuming management properties with more easily managed properties;
- Exchange into property that can accommodate the taxpayer’s trade or business (e.g. taxpayer who owns apartment complex can trade into manufacturing plant);
- Exchange fully depreciated property to obtain the benefit of a new depreciation schedule;
- Relocation of taxpayer’s business;
- Relocation of investment property to accomplish ease of management.
If you are interested in learning more, please contact me.
Realtor Associate (RS-79457)
Hawaii Life Real Estate Brokers
Disclaimer: Content in this blog for information purposes only. You should always consult with your personal tax advisor or attorney for matters involving taxation and estate planning.