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Thanks to IRC §1031, a properly structured exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC §1031 (a)(1) states:
"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment."
To understand the powerful protection an exchange offers, consider the following example:
- An investor has a $200,000 capital gain and incurs a tax liability of approximately $70,000 in combined taxes (depreciation recapture, federal and state capital gain taxes) when the property is sold. Only $130,000 remains to reinvest in another property.
- Assuming a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $520,000 new property.
- If the same investor chose to exchange, however, he or she would be able to reinvest the entire $200,000 of equity in the purchase of $800,000 in real estate, assuming the same down payment and loan-to-value ratios.
As the above example demonstrates, exchanges protect investors from capital gain taxes as well as facilitating significant portfolio growth and increased return on investment. In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the IRC. For instance, an accurate understanding of the key term "like-kind" - often mistakenly thought to mean the same exact types of property - can reveal possibilities that might have been dismissed or overlooked. API is your resource to obtain accurate and thorough information about the entire exchange process.
Include language stating the intent to perform a §1031 tax deferred exchange in the Purchase and Sale Agreement:
“Buyer is aware that Seller intends to perform an IRC §1031 tax deferred exchange. Seller requests Buyer’s cooperation in such an exchange and agrees to hold Buyer harmless from any and all claims, liabilities, costs or delays in time resulting from such an exchange. Buyer agrees to an assignment of this contract to Asset Preservation, Inc., by the Seller.”
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What is Like-Kind Property? |
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Pursuant to IRC §1031, capital gain tax deferment requires the exchange of "like-kind" relinquished property for other "like-kind" replacement property. Contrary to the commonly held misconception that exchanged properties must be of the exact same type - for example, that bare land be exchanged for bare land or an income property be exchanged for another income property - the actual definition of "like-kind" is far more empowering in its flexibility. Any real property held for investment or real property used in a trade or business can be exchanged for any other real property held for investment or real property used in a trade or business. |
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| POTENTIAL "LIKE-KIND" PROPERTY EXCHANGES AND BENEFITS: |
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Requirements for Full Tax Deferral |
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A properly structured exchange is the transfer of property for property, thus deferring capital gain taxes. Any cash received, any reduction in mortgage or any other non-like-kind property received is considered "boot" and is taxable to the extent of the capital gain. To fully defer all capital gain taxes, an Exchanger must meet two requirements:
1 REINVEST ALL EXCHANGE PROCEEDS - If an Exchanger does not reinvest all exchange proceeds from the sale of the relinquished property, the balance received is considered "cash boot," and gain may be recognized on that amount.
2 ACQUIRE PROPERTY WITH THE SAME OR GREATER DEBT - If an Exchanger does not acquire a replacement property with an equal or greater amount of debt, he or she is relieved of a debt obligation, which is considered "mortgage boot." The IRS considers this reduction in debt a benefit to the Exchanger; therefore, it is taxable, unless it is offset by adding equivalent cash to the replacement property purchase.
Asset Preservation, Inc. does not provide tax or legal advice. Investors should always seek the advice of their tax and/or legal advisors regarding their specific situation. | |
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