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A like-kind real estate exchange defers gain
If you own real estate that you are planning to sell at a gain, consider a like-kind – or Section 1031 – exchange.
Internal Revenue Code Section 1031 allows you to defer gain on real or personal property used in a business or held for investment. Instead of selling the asset, you exchange it solely for property of a “like kind.”
For personal property, like kind means property of the same asset or product class. With real estate, virtually any other type of real estate qualifies, so long as it is business or investment property. For example, you can exchange an office building for a warehouse. But you cannot exchange your personal home, unless you first convert it into investment property.
Since it is often difficult to locate someone with a desirable property who also wants to swap it for your property, most Section 1031 exchanges involve the services of a middleman, called a qualified intermediary (QI).
In a deferred Section 1031 exchange, you sell your property, but the buyer pays the purchase price directly to the QI. You then have 45 days to locate a suitable replacement property, and you must have the QI purchase it for you within 180 days of the initial sale.
The same notion works in reverse. Suppose you find an ideal investment property for sale that you would like to trade into, but the owner does not want a trade, and there is no time to sell an existing property.
In a reverse Section 1031 exchange, a special type of QI called an exchange accommodation titleholder (EAT) acquires title to the replacement property before you sell your property. You then have 45 days to identify the property you are going to sell and 180 days to complete the transaction.
Although a section 1031 exchange has a number of benefits, there are a number of issues to keep in mind:
If you receive sale proceeds or acquire title to replacement property before you sell the property you are exchanging, gain will not be deferred. That is why you use a QI or an EAT.
If you exchange your property for a property of lesser value and receive cash or other non-like-kind property to make up the difference, gain will be taxable up to the value of this difference. You may be able to have your QI use the cash to make improvements to the property or acquire additional like kind property to avoid paying tax on the gain.
Those in the business of buying and selling real estate cannot use Section 1031 to defer tax on property held primarily for sale. Unfortunately, the line between a dealer and an investor is not always clear.
Exchanging real estate for an interest in a partnership that owns real estate or an interest in a real estate investment trust (REIT) does not qualify as a like kind exchange.
The exchanged property and the replacement property must be similarly titled. If you and your spouse own property as joint tenants, you should acquire the replacement property as joint tenants.
If property received in a like-kind exchange between related persons is disposed of within two years after the date of the last transfer that was part of the like-kind exchange, the original exchange will not qualify for deferral.
If you are considering a Section 1031 exchange, it is a good idea to consult with your tax adviser. Also, with tax rates scheduled to increase in 2013, deferring taxes today may result in your paying more tax later.
The technical information here is necessarily brief. No final conclusion on these topics should be drawn without further review and consultation. Please be advised that, based on current IRS rules and standards, the information contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty assessed by the IRS.
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