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An opportunity to defer taxes and build wealth arises when and individual or entity sells an investment property for more than he or it purchased it for. Generally, tax on the seller’s capital gain is due upon the sale of property. However, Internal Revenue Code Section 1031 provides an exception to this rule and allows a seller of investment property (referred to here as the “Relinquished Property”) to re-invest his proceeds into another investment property (referred to here as the “Replacement Property”) as part of a qualifying “like-kind” Exchange. Often misunderstood by taxpayers, capital gain deferred in an Exchange is tax-deferred, but it is not tax-free.
Owners of property that qualify for an Exchange include individuals, C corporations, S corporations, general and limited partnerships, limited liability companies, trusts, and any other taxpaying entity. As mentioned above, the property exchanged must be held for investment purposes. Therefore, property used for personal use, such as a primary residence, a second home, or vacation home, does not qualify for an Exchange. Furthermore, both properties involved in an Exchange must be “like-kind”. Like-kind is commonly defined as property of the same nature, character, or class. Usually, real property will be considered like-kind to other real property. For example, real property that is improved with a commercial building is like-kind to vacant land. However, there are exclusions. Real property within the United States is not like-kind to real property in another country and improvements that are conveyed without the land are not like-kind to land. In order to take full advantage of the Exchange, the seller must re-invest all of his equity into the Replacement Property and obtain the same or greater debt on the Replacement Property.
The first step in the Exchange process is selling the Relinquished Property. It is imperative that the seller retain a qualified, professional Exchange facilitator known as an Intermediary. Because the seller may not receive actual or constructive receipt of the proceeds from the sale of the Relinquished Property, the Intermediary holds the proceeds until the closing on the purchase of the Replacement Property.
There are strict time limits to complete the Exchange or the entire gain will be taxable. As such, within forty five (45) calendar days of the sale of the Relinquished Property, the seller must identify the Replacement Property (or Properties) he wishes to acquire. The Replacement Property must be of equal or greater value than the sale price of the Relinquished Property. Further, the seller must clearly identify the Replacement Property in a written document often referred to as an Identification Notice. The Identification Notice must be executed by the seller and delivered to the Intermediary. In fact, delivering the Identification Notice to an attorney, real estate agent, accountant or similar agent is not sufficient. Moreover, the identification of the Replacement Property must be specific, including the legal description and street address.
The next step in the Exchange process is purchasing the Replacement Property. The closing of the Replacement property must occur no later than one hundred and eighty (180) calendar days after the sale of the Relinquished Property or the due date (including extensions) for the filing of the tax return for the tax year in which the transfer of the Relinquished Property occurs, whichever is earlier.
The Exchange must be reported to the Internal Revenue Service on Form 8824 and filed with the tax return for the year in which the Exchange was performed.
It is important that the property owner consults with a tax professional and tracks and adjusts the basis correctly to comply with the stringent guidelines set forth in Section 1031 of the Internal Revenue Code. When the Replacement Property is sold (not as part of an Exchange), the original deferred gain, plus any additional gain realized since the closing on the Replacement Property, is subject to tax.
Internal Revenue Code Section 1031 Tax Deferred Exchange (Part II)
By performing an Exchange the property owner will be permitted to defer all Capital Gains Taxes (15%/20% Federal), Depreciation Recapture (25% Federal) and Medicare Surtax (3.8%). In order to obtain a deferral of the entire capital gain tax, the Exchanger must:
- Purchase property of equal or greater value
- Reinvest all of the net proceeds from the Relinquished Property
- Obtain equal or greater financing on the Relinquished Property
In the event the Exchanger does not follow the above rules, they will be subject to capital gains tax.
A “Reverse Exchange” is typically used when an Exchanger needs to close on the Replacement Property prior to closing the sale of the Relinquished Property. Internal Revenue Code Section 1031 does not allow the taxpayer to own both the Relinquished Property and Replacement Property at the same time. As such, a Reverse Exchange involves a third party holding title to the Relinquished Property until the taxpayer is able to complete the Exchange. This third party is referred to as an Exchange Accommodation Title Holder (“EAT”).
Revenue Procedure 2000-37 provides a safe harbor for Reverse Exchanges. The Internal Revenue Code will not challenge the status of a Reverse Exchange so long as its structure is in accordance with the Revenue Procedure. The Revenue Procedure provides that a new entity must be used by the Exchanger to hold title to either the Replacement Property or the Relinquished Property in the form of a disregarded special purpose entity. A Qualified Exchange Agreement is used to govern the relationship between the Exchanger, the EAT and the holding entity. For Federal Tax Purposes in a Reverse Exchange, the EAT is the beneficial owner.
The timelines still exist in a Reverse Exchange. Within 45 days of the EAT acquiring title the Exchanger must identify the Relinquished Property and within 180 days the EAT must transfer the property.
Although there are some additional costs associated with performing a Reverse Exchange, it does not require double payment of Florida documentary stamp taxes.
If you would like more information on performing a tax deferred Exchange, please contact Nicole Villarroel.