Every week, Mansion Global poses a tax question to real estate tax attorneys. Here is this week’s question.
My friend is encouraging me to take advantage of the U.S. 1031 tax deferral by buying a new property soon after I sell my investment property. Can you explain how this works?
“Section 1031 is a must-do when selling investment real estate,” said G. Scott Haislet, a certified specialist in taxation law and certified public accountant in private practice in Lafayette, California. A sale of highly appreciated real estate will trigger significant tax, but a 1031 exchange defers that tax, he said.
Section 1031 allows you to postpone, but not avoid, paying tax on the gain if you reinvest the proceeds in a similar property as part of a qualifying like-kind exchange, said Michael A. Gillen, director of the Tax Accounting Group at Duane Morris law in Philadelphia.
Only business or investment properties qualify. Personal residences, second homes and vacation homes do not, he said.
To be eligible for Section 1031, a taxpayer must “exchange like kind” property and hold both properties “for investment,” Mr. Haislet said.
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The IRS considers two separate transactions an “exchange” when property is sold in one transaction and a replacement property is bought in a separate transaction, Mr. Haislet explained, “provided the taxpayer hires a ‘qualified intermediary’ (a holding agent) under an ‘exchange agreement.’”
“Like kind” is broadly defined. As long as the exchange is real estate (land and/or buildings) for real estate, or non-real estate personal property for non-real estate personal property, it should qualify, Mr. Gillen said. However, real property in the United States and real property outside the United States are not like-kind properties, he added.
Here’s how the U.S. tax rules work, per Mr. Gillen: In a straight asset-for-asset exchange, if you exchange an apartment building (investment property) you bought for $100,000 that’s now valued at $1 million for a bigger apartment building (investment property) that’s also valued at $1 million, you defer the gain of $900,000 on the exchange. Your original tax basis of $100,000 transfers to your new building.
The exchange will still have to be reported for tax purposes, but no tax on the gain is due yet. It’s due when the replacement property is ultimately sold, and not part of another exchange, Mr. Gillen said.
Frequently, properties aren’t of equal value, so cash or other (non-like-kind) property, known as “boot,” is added to make up the difference. Consult your tax attorney to find out how boot affects your tax basis.
Beware that time limits apply to like-kind exchanges. “The property to be received in an exchange must be identified within 45 days of the relinquishment of the property to be transferred,” Mr. Gillen said.
After the property is identified, he elaborated, it must be received on or before the earlier of: 180 days after the relinquished property is transferred or when the tax return for the transferor is due for the tax year in which the relinquished property is transferred.
Like-kind exchanges can be an excellent tax-deferral strategy. But exchanges, especially those involving boot, can get complicated, so always consult with a qualified tax professional, Mr. Gillen advised.
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