Last week we discussed what is an IRS Code Section 1031 Exchange and the benefit of the 1031 Exchange: the deferral of capital gains tax when investment property is sold, as long as the profit is reinvested in replacement property. But what are the rules of the exchange in order to qualify for the capital gains deferral?
First, the definitions; the property that is sold in a 1031 Exchange is referred to as the “relinquished property,” and the property that is subsequently purchased is referred to as the “replacement property.” There may be one or multiple relinquished/replacement properties. As discussed last week, any real property can be exchanged for other real property within the same state or other state(s). Property outside of the United States, however, is not considered like kind.
In order to avoid paying any taxes on the sale of the relinquished property, the replacement property must be of equal or greater value than the net sales price of the relinquished property. Also, if all of the proceeds from the sale of the relinquished property is not reinvested in the replacement property, and some of the cash is taken out, this is known as “boot.” Boot is taxable up to the amount of total realized gain on the sale.
One thing to be careful of is utilizing less debt with the purchase of the replacement property. For example, the relinquished property is sold for $2,000,000 with debt in the amount of $1,000,000 and the replacement property is purchased for $2,000,000 using $500,000 of debt. Even though the replacement property’s value is equal to (or more than) the replacement property, the $500,000 difference in debt would be taxable. This can be offset, however, if more cash is put into the replacement property purchase.
The timing of identifying and purchasing the replacement property is very important. The possible replacement property(ies) must be identified within 45 calendar days of the sale date of the relinquished property. Up to three properties worth any amount can be identified, but only one (or two or three) must eventually be purchased within the time frame below. Keep in mind all of the net proceeds must be reinvested or there will be taxable boot. More than three replacement properties can be identified, but their value cannot exceed 200% of the value of the relinquished property. Otherwise, 95% of what was identified will need to be purchased.
The replacement property must be purchased within 180 calendar days of the sale of the relinquished property. The actual rule, however, states that the closing on the replacement property must be completed on the earlier of 180 days or the next due date to file an income tax return, including extensions. So, if the relinquished property is sold between October 17 and December 31, the replacement property must be purchased on or before April 15 if the seller’s tax return is filed accordingly or an extension request is made in order for the full 180 days to complete the transaction to be allowed. The tax return and name appearing on the replacement property has to be the same as that on the relinquished property. If the property is owned using a wholly-owned limited liability company, known as a single-member LLC, the LLC is treated as the taxpayer.
Next week’s edition of This Week in Real Estate will discuss the step by step process to accomplish a 1031 Exchange.
ABOUT JAMES LANDON
Jim Landon has practiced real estate law since 2002 and has been involved in real estate investment and construction for most of his life. Jim’s practice focuses on real estate transactions and land use.
Jim represents individuals and privately and publicly held companies in the purchase, sale, leasing, financing, and development of real property. He also represents title insurance companies on commercial purchases and refinancing transactions, as well as providing third-party legal opinions regarding Delaware law related to Delaware entities.
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