1031 Commonly Asked Questions


Here are some commonly asked questions about 1031 exchanges:

 

What is a Tax Deferred Exchange?

 

Internal Revenue Code 1031 allows taxpayers the opportunity to defer taxes owed upon the sale of investment or income property by exchanging the property for other like-kind property.

 

What is the Difference Between A Sale and An Exchange?

 

A sale is an exchange of property for cash, which is not 'like-kind' to real estate and therefore is taxable. An Exchange is a non-taxable sale because the taxpayer will sell investment property and replace it with property, which is Iike-kind.

 

Should I Consider an Exchange?

 

This is an individual decision based on your overall retirement plan and investment goals. Although you may have a financial or tax advisor, ultimately you the taxpayer will be writing the check to the Internal Revenue Service if you decide to sell and pay the capital gains tax.

 

What is Capital Gains Tax?

 

Capital gains is the difference between a sales price and the 'adjusted basis' in a property. To put it simply, when you purchase investment property the purchase price is your basis. If you make capital improvements to the property, the value of those improvements will increase the basis in your property, adjusting the basis upwards. Depreciation is a benefit to owning investment property, which allows for yearly deduction of a portion of the value of the property. Any depreciation taken is a reduction in the basis of the property.

 

Isn't Capital Gains Tax only 15%?

 

No. Gain from appreciation (the increase in your property value) is taxable currently at 15%. However the gain from the depreciation is taxed at 25%. In addition, most states will charge state taxes.

 

Current Tax Law

2008

Dec. 31, 2008

Top Long-Term Capital Gains Tax

15%

15%

20%

Lowest Long-term Capital Gains Tax

5%

0%

 

10%

 

 

 

 

 

 

 

 

 

 

Won't I Have to Pay the Taxes Eventually?

 

When you eventually pass away, your estate is transferred to your heirs at a 'stepped up basis'. Your heirs will pay inheritance taxes on the current market value of the estate. However, your deferred capital gains taxes are forgiven.

 

What Does Like Kind Mean?

 

IRC§1031(a) (1) allows for the exchange of property held for productive use in a trade or business or for investment for like-kind replacement property. A myriad of court cases and IRS rulings have established the definition of the like-kind real estate to be very broad.  Examples of the like-kind property include single-family rentals, multi-unit housing, commercial, industrial or professional properties, ranches and bare land. Provided a property has not been personally used, such as a principal residence or second home, it should qualify for exchange treatment.

 

Why do I Need A Qualified Intermediary?

 

In 1991 the Treasury provided taxpayers with 'safe harbor' guidelines for deferring taxes on the sale of investment or income property. These guidelines call for the use of a third party, a Qualified Intermediary, to allow the Exchangor to complete a sale and repurchase as far apart as 180 days without any taxable event.

 

How do I Choose a Qualified Intermediary?

 

The taxpayer should select this firm based on their knowledge and expertise, experience, and integrity. Starker Services, Inc. is the nations largest and oldest independently owned Qualified Intermediary.

 

After I have Chosen A Qualified Intermediary, Then What?

 

Upon the closing of the sale property the taxpayer must adhere to two timetables. First, the taxpayer must identify possible replacement properties within 45 days of closing on the sale property. You will do so by listing the properties and forwarding it to your Qualified Intermediary. Second, the taxpayer must close on at least one of the properties identified within 180 days. Both of these time frames begin at the close of your sale property.

 

How Much Do I Have To Spend On The New Property To Defer All Taxes?

 

The taxpayer will be looking for property or properties that are at least equal to the sales price (minus the closing costs) of the property being sold. In addition, all of the funds that your Qualified Intermediary is holding should be used towards the acquisition of your new property.

 

Can I Take Any Cash Out Of The Sale?

 

Yes. Any cash received will be subject to capital gains tax. There are strict rules for receiving cash out of the exchange. If done correctly this will allow for a partially tax deferred exchange.

 

When Do I Have To Make This Decision?

 

Taxpayers electing to use IRC Section 1031 must do so prior to closing and receiving proceeds from the sale of their property.

 

Does This Mean We'll Be Audited?

 

No more than if you sold the property. The tax-deferred exchange has been a part of the IRS tax code in some form since 1921, in fact it was introduced by the IRS. Just like Individual Retirement Accounts, if you follow the rules and guidelines the government lets you defer the taxes you would have paid until you later sell the property and take the cash.

 

 

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