Investor's 1031 exchange

Tax Free Exchanges

 What if someone was to tell you that you could invest in a property, depreciate it out, then trade it for another property and all the time avoid legally capital gain taxes? Meanwhile the property would appreciate and no taxes would be due on the added value. You could borrow on equity to take the money and still show no income. As long as you continued to trade instead of sell properties, the tax man could be put off indefinitely and upon death, the property would be transferred to your heirs at the current market value and if sold by them, no taxes would be due?

WELCOME TO THE WORLD OF TAX FREE EXCHANGES!

This information is presented for education purposes. It is presented to assist investors in understanding how the system works. The supplier of this information is not rendering accounting, legal or other professional services. If the reader needs the services of competent accounting, legal or other professional services; then the reader should seek these services. The presenter has taken care to provide clear and accurate information, but the laws can change and the provider does not assume legal responsibility for the actions of the reader caused by their interpretations or actions after reading this information.

Tax Free Exchanges are defer taxes that would normally be paid upon sale of a property. It allows the purchase of property, using the equity of previously owned properties as down payment. It allows the property to increase basis and possibly qualify for more depreciation. Using your money before being taxes allows you to have more favorable financing on the new property. You can diversify or consolidate a portfolio and even distribute your holdings to other geographic areas.

An exchange permits the realized gain from the sale of a property to pass on to the next property without being recognized (taxed) by the IRS until that new property is disposed of in the future. This allows the seller to acquire a larger property or a smaller mortgage on another property, possibly generating more cash flow.

Whether a tax free exchange is a good thing may be determined on how much tax would have to be paid at the time of sale and what future plans the investor has for the money from the sale. If reinvestment in real estate is the goal, then a tax free exchange should be considered.

How do you calculate the taxable gain? Upon sale, the owner must pay taxes on the gain, not the equity in a property. The gain is calculated by finding the Adjusted Basis.

ADJUSTED BASIS

Original Cost Plus Improvements Minus Depreciation = Adjusted Basis

REALIZED GAIN

Sale Price Minus Cost of Sale Minus Adjusted Basis = Realized Gain which is Taxable.

To avoid this taxable situation an Exchange may be preferred by the seller. An exchange is considered as continuing your investment if you are trading one property held for investment or use in a trade or business for another "Like-Kind" property which will also be held for investment or used in a trade or business.

This means that there can not be net loan relief (you owe less money after the exchange than you owed before the exchange). You also can not receive cash or boot (any non-cash asset) in the exchange.

How is the exchange accomplished? The easy way is to sell your property. Then you must have the proceeds of the sale placed in a qualified escrow account for the purchase of the exchange. You do not receive the money and you can not withdraw or use the money from the escrow account. You must clearly demonstrate that your intent is to do an exchange. This is easily accomplished by an addendum to your listing contract and a second addendum in your purchase offer. There are some other rules. The Escrow agent must not be someone in your normal employment, like your attorney. It can not be you or anyone connected to you. Many large escrow company's and title companies are geared up to be escrow holders. The escrow agreement must clearly state that you have no right to receive, pledge, borrow or otherwise obtain the benefit of the cash or cash equivalents held in escrow.

You have 45 days from the day of the closing of your old property to identify a replacement property. To identify a property you must send a written document signed by the taxpayer and delivered in some manner to the escrow agent within the 45 day period after the sale of the original property. The written document must identify the new property by address or legal description, no ambiguously described properties will be accepted.

The new property must then close within 180 days from the day of your closing on the old property, or the date your taxes are due (with extensions), whichever occurs the earliest. The day the old property sells begins both time clocks. As long as the only thing received is a like-kind property, you do not have to pay any taxes on your gain. These days are calendar days and are absolute. Weekends or holidays will not give you a grace period.

At the closing of the purchased exchange property, the escrow agent must release the proceeds of the sale directly to the attorney or title company closing the purchase. They will then distribute the the funds according to the offer to purchase agreement.

You can identify up to three properties on any value as long as the combined value does not exceed two times the value of the property you sold. You can also identify any number and value of properties as long as you actually acquire 95% of the combined fair market value of the properties you identified. Another choice is to identify any number of properties as long as you close on them before the end of the 45 day identification period.

WARNING - If you identify too many properties, IRS will generally ignore the exchange concept and will tax you as if you had just sold.

TAX FREE VS TAX DEFERRED. Each exchange is tax deferred. If you ever sell the property and take the proceeds, you have to pay the taxes. However, if the investor continues to do tax free exchanges throughout his life time and passes on, his heirs will receive the inheritance at it's current, fair market value. If no estate taxes are generated, and the heirs sell the property, there is no gain from the time they owned it and no taxes are due.

Another thing you must consider are State laws. You must compare the State and Federal laws and become aware of any differences or potential problems.

You should get a copy of IRS Form 8824. Personal residences do not qualify for exchanging. Related parties must hold a property for two years after the date of the exchange to defer taxes. There are also special rules on raw land, and improved land where you have taken accelerated depreciation. Part of that depreciation may be taxable even in an exchange. You can receive interest on the escrowed proceeds, but only after the exchange has taken place.

I recommend that you use experienced accountants or attorneys in making exchanges.

REMEMBER - The basis of the new property will be reduced by the unrecognized gain from the old property