Tax Deferred Exchanges: An Introduction
There is a way to defer the taxes on the "sale" of a property being used or held for investment purposes or trade. Its referred to as a Tax Deferred Exchange. You may also hear it called a "Deferred Like-Kind Exchange" or a "Section 1031 Exchange" or a variety of other terms; we're going to stick to tax deferred exchange or TDE. First, let me say that you must use, by law, what is called a "qualified intermediary" to complete a TDE. Its also highly recommended that you have an attorney that can explain the legal aspects of the exchange.
In simple terms…you can defer (postpone), and in some cases, eliminate the capital gains tax on an investment property you're selling. The catch? You have to be purchasing a "like-kind property" to "replace" the one you're selling. In short, its the simultaneous to semi-simultaneous swap of one property for another. This allows you to maintain more of your money to put into a replacement property. I'll go into detail on the definition of "like-kind" a bit later.
- A bit of history -
Section 1031 refers to the tax code in which you can find the rules and regulations that govern tax deferred exchanges. The ability to defer tax on investment property has been around since the 1920s. However, complexity and convoluted details allowed only the most expert of investors and tax preparers to partake in 1031's use. However, that all changed with the Omnibus Budget Act in 1991. That act clarified the rule's use and opened it up to a wider range of consumers. Since then, TDEs have become much more popular as a tool to defer capital gains tax on investment or trade property.
The tax code "provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment." The premise of the code being that economic gain has not been obtained in a way that generates immediate funds to pay any tax. It holds that the tax payer's investment is still the same and that only the form has changed.
- Why Choose a Tax Deferred Exchange -
If you're an investor by trade or someone who plans on being in the world of investing for some time, then a TDE is the perfect formula for you. You will save 15% on capital gains tax that you would pay in a straight sale-for-profit transaction. Thats 15% more of your money that you have to put into your replacement property. You can then grow your investments at a faster pace.
Simple Example: If you make $100k from a typical property sale, you're going to pay around $15,000 (15%) of that in capital gains tax. You now have $85,000 to invest in more property.
Lets make that a TDE. You get $100k from the sale of a property. You now want to buy another investment property. In the example above, your buying power is at $85k. Well, with a TDE, you're buying power is the full $100k (important note: the replacement property must be equal or greater in value to the sold property - more on that below). Thats a very simple example used to illustrate the benefit of a TDE - there may at times be other expenses and taxes involved, depending on your situation.
- Requirements of a Tax Deferred Exchange -
There are several requirements to complete a TDE. Some are a little harder to convey and will require the expertise of your qualified intermediary (QI) or attorney; I won't go into those details with this blog. I'll touch on some of the basic, but still important factors that one should have knowledge of before entering into the TDE process.
*Choose a Qualified Intermediary
One of the most important requirements of a TDE is that the transaction MUST be handled by a licensed qualified intermediary, sometimes called a certified exchange specialist. By law, If the funds used in the TDE transaction are not handled by a QI, then everything becomes taxable. You want to make sure that you interview several QIs and get references (from other investors, not your real estate agent, as it could create a conflict) for whoever you choose. You also want to make sure that they are bonded and insured and from a reputable organization whose sole occupation is tax deferred exchanges.
***Find a qualified intermediary experienced in Atlanta Real Estate.***
*Property Must be "like-kind"
Another important factor, and perhaps the most important is that the property you're selling and buying must be "like-kind" properties. Both properties must be used or held for a trade, business or for investment purposes. Properties used for your principle residence, 2nd residence or say, a vacation home, do not qualify. The IRS says "like-kind property is property of the same nature, character or class. Quality or grade does not matter." Your guide should be the purpose and price of the replacement property. Why do I say price? Well, that brings us to another important rule.
*Price and Funds
Two other key factors involve the price and funds used during the transaction. First, the total purchase price of the replacement "like kind" property must be equal to, or greater than the total net sales price of the relinquished property. Second, all the equity received from the sale of the relinquished property must be used to acquire the replacement, "like kind" property. So, that 100k from above - you must use all of it to purchase your like-kind property. You are not permitted to pocket any of the funds.
Two remaining factors I'll discuss are in regard to timelines. There are several different types of TDEs that I won't go into. The most common, that I'm discussing here, is a 'delayed TDE.' That means you sell your first property and then go looking for a replacement property.
The Identification Period: That states that you have 45 days from the sale day of your property to find the replacement property. That timeline will not be extended under any circumstances (ie. if it falls on a weekend or Holiday).
The Exchange Period: You must close on the replacement property no later than 180 days after closing on your sold property. A highly important note - your 180 days can be cut short by tax day. So, if your 180 day timeline happens to include April, you're 180 day exchange period is up on tax day (usually April 15th, but April 18th this year). Make sure you discuss that with your QI.
A couple important notes to discuss with your QI:
- You're not limited to just one replacement property...see if purchasing more than one is right for you.
- Will tax day disrupt your timelines. If so, ask about your options.
- Which exchange process is best for your situation.
What you've just read is a basic and simple introduction into Tax Deferred Exchanges. There are several different types of exchanges, most involve more experienced investors - your QI is the best source on which is best for you. Note - you want to make sure the QI you choose is an expert on the specific type of exchange you need.
There are several great resources for more information on Tax Deferred Exchanges:
Adam. Thank you for the informative blog on a 1031 exchange. You have done your homework on explaining the benifits of the 1031 tax exchange. This is one reason real estate is still the best investments for the future. Where else are you going to find a such a great tax benifit.
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