In doing my research this morning I came across the Treasury Office’s Tax Analysis of like-kind exchanges. For tax year 2007 (the last year in which detailed records are kept) taxpayers saved a total of $82.6 billion (with a B), in capital gains taxes using these exchanges. I thought today would be a good day to talk about IRC §1031, just in case someone out there is considering a like-kind exchange.
IRC §1031 is extremely intricate, but I will try and make it understandable for my readers. A 1031 Exchange is something called a “like-kind exchange.” It is just what it says it is. You exchange a property for another property that is like-kind. A perfect, everyday, like-kind exchange would be when you go to a car dealer, and trade your car in for another car. You are given an allowance for your vehicle, and then you have to pay the difference. Most people are familiar with trading in a car, so let’s expand on this a little bit to get the true concept.
Let’s say that you own a rental property that you bought for $60,000. You have had the property for ten years, and you have been told by a realtor that you can now sell that property for $200,000. This would make you a profit of $140,000, and you would be responsible for $21,000 in capital gains tax. With the money that you are going to make, you want to buy two different rental properties. Your option is to sell the property, recognize $140,000 gain and pay the $21,000 in taxes, which then results in you having less money to invest in the next property. Instead of doing that, you may want to consider the advice of a really good accountant, who recommends that you consider doing a 1031 Exchange. In a 1031 Exchange, you would hire something called a Qualified Intermediary (QI), that would take possession of the $140,000, and when you decide on the properties to buy the QI would then purchase the property with your money. If you do it this way, you save $21,000 in what would otherwise be your tax liability. Pretty nice…huh? HOWEVER, (I have a job because of the “howevers”) there are certain rules you have to follow. The rules that I am about to tell you are “hard and fast.” There are no exceptions, and missing a deadline will cause the transaction to be taxable.
You have 45 days AFTER the transaction to identify up to three properties that you want to roll your gain into. Why would you identify more than one property? Deals can fall through, and you want to have a couple of backup property options, should your first choice property not work out as planned. You must identify these properties in writing to your QI. After you identify the property, you have 180 days OR the due date of the tax return plus extensions to TAKE POSSESSION of the property. What I am about to tell you isn’t a written rule, but Tax Court Cases have shown how the Court will rule, so I prefer to go by that. You must hold the replacement property for AT LEAST two tax returns.
1031 Exchanges aren’t just limited to real estate, you can use them with any income producing property, such as with a business. There are some exceptions:
(A) stock in trade, or other property held primarily for sale,
(B) stocks, bonds, or notes,
(C) other securities or evidences of indebtedness or interest,
(D) interests in a partnership,
(E) certificates of trust or beneficial interests, or
(F) choses in action.
Also, you have to be careful about the QI that you select to work with. Remember that there are plenty of unscrupulous businesspeople out there who will gladly steal your money, or other things. So, as with all your financial transactions, be sure to do your homework, and make sure you are dealing with a reputable company.
This is just a very brief article about 1031 Exchanges, there are a lot of ins and outs, but this gives you a general idea.