Capital gains tax is the tax imposed on the profit from property sold. For the properties owned over a year, capital gains tax varies between 22 percent (if the property is individually held) to 30 percent (if the property is held through an entity). The 30 percent was originally higher but under Trump’s tax reduction initiative, it has since been reduced.
Talking to many New York real estate attorneys and other real estate professionals, and in light of the new administration, there is concern that capital gain taxes will increase in the next couple of years. A well-structured 1031 exchange can resolve income tax problems by providing a tax deferral for taxpayers who want to sell their low-basis investment property, but do not want to pay federal and state income taxes.
To explore your options and obtain guidance on navigating capital gains tax and 1031 exchanges, especially if you are holding a 1031 exchange property, it is recommended to consult with a New York 1031 lawyer. At Sishodia PLLC, our experienced lawyers can provide valuable insights and assistance tailored to your specific needs. Contact us at (833) 616-4646 to schedule a consultation.
A well-structured 1031 exchange can resolve income tax problems by providing a tax deferral for taxpayers who want to sell their low-basis investment property, but do not want to pay federal and state income taxes.
The main advantages of a 1031 exchange are: an increase in purchasing power, leverage, management relief, increase in cash flow, diversification, and more. Investors can make the most out of the 1031 tax-deferred exchange to obtain a higher-valued investment property.
Section 1031 of the Internal Revenue Code provides that “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 for productive use in a trade or business or for investment”.
A 1031 Exchange, also known as Deferred Exchange, is one of the most popular tax strategies available when selling and buying real estate. It allows the owner of a property (Relinquished Property) to defer tax gain on the transaction to a future date and therefore have more cash available for the purchase of new property (Replacement Property).
It is important to note that the like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the Replacement Property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the Replacement Property, is subject to tax.
Rationale and Benefits of 1031 Exchange
The rationale behind the tax deferral is that the taxpayer’s investment is still the same, only form has changed (e.g. vacant land exchanged for apartment building) and it would be unfair to force the taxpayer to pay tax on a “paper” gain.
There are several benefits in doing an exchange instead of selling the property:
· By deferring the tax, the owner has more money available to invest in another property.
· Any gain from depreciation recapture is postponed.
· Owners can acquire and dispose of properties to reallocate the investment portfolio without paying tax on any gain.
Types of Exchanges
· Simultaneous Exchange: when the exchange of the Relinquished Property for the Replacement Property occurs at the same time
· Delayed Exchange (most common): when there is a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property. There are strict time limits to follow as set forth in the Treasury Regulations.
· Build-to-Suit (Improvement or Construction) Exchange: the taxpayer can build on, or make improvements to, the Replacement Property using the exchange proceeds.
· Reverse Exchange: when the Replacement Property is acquired prior to transferring the Relinquished Property.
| Exchange Type | Description |
|---|---|
| Simultaneous Exchange | The exchange of the Relinquished Property for the Replacement Property occurs at the same time. |
| Delayed Exchange (most common) | There is a time gap between the transfer of the Relinquished Property and the acquisition of the Replacement Property. Strict time limits, as set forth in the Treasury Regulations, must be followed. |
| Build-to-Suit (Improvement or Construction) | The taxpayer can use the exchange proceeds to build on or make improvements to the Replacement Property. |
| Reverse Exchange | The Replacement Property is acquired prior to transferring the Relinquished Property. |
Requirements of a Valid Exchange
· Qualified Use Test – both the Relinquished Property and the Replacement Property must be held either for use in a trade or business or for investment. A sale of business property is not required to be replaced with other business property; it can be replaced with investment property or vice versa. Property acquired for immediate resale or a taxpayer’s personal residence do not qualify.
· Like-Kind Standard – the “Like-Kind” standard is broadly interpreted and easy to satisfy. Generally, while both properties must be held either for use in a trade or business or investment, they do not have to be of the same nature.
· Exchange Requirement – the Relinquished Property must be exchanged for other property, rather than a sale followed by a purchase.
· Reinvest the Equity & Exchange Equal or Up in Value – a property owner must first reinvest all of the equity in the Relinquished Property into the Replacement Property. Second, the purchase price of the property acquired must equal or exceed the sale price of the Relinquished Property.
How Long Do You Have to Hold a 1031 Exchange Property?
The IRS provides clear guidelines regarding 1031 exchange properties, with one essential requirement being that both the relinquished and replacement properties must be intended and utilized as investment properties to qualify for tax deferment under Section 1031. However, the specific duration for which these properties must be held is not explicitly defined by the IRS. Instead, the IRS states that a “sufficient period of time” is required, leaving room for interpretation and potential uncertainty regarding qualification requirements.
The holding period for a 1031 exchange property is made by the IRS on a case-by-case basis, as they do not establish definitive rules for it. However, previous IRS rulings suggest that a holding period of two years is generally considered sufficient to satisfy the qualified use test. In addition, some court rulings have adopted an even more flexible stance regarding this issue.
Numerous tax advisors recommend that property owners involved in 1031 exchanges adhere to a minimum holding period of one year. They also suggest keeping comprehensive documentation of rental income, depreciation, expenses, and other relevant evidence to demonstrate the property’s status as an investment property. It is important to note that if you intend to utilize your replacement property as a primary or secondary residence in the future, it must also adhere to the IRS’s safe harbor rule, which entails meeting specific requirements outlined by the IRS.
To ensure compliance with the appropriate guidelines and regulations, it is best to consult with a qualified New York City 1031 lawyer. At Sishodia PLLC, our lawyers can provide personalized guidance based on your situation and the applicable tax regulations. Contact us to schedule a consultation today.
How to Defer Capital Gains Tax Without Doing a 1031 Exchange?
If you’re looking to postpone capital gains tax on appreciated assets but a 1031 exchange doesn’t fit your situation, a Deferred Sales Trust (DST) might be the solution you need. A DST operates under the principle of an installment sale, allowing you to break down the sale of an asset into multiple payments over time, which can defer the capital gains taxes associated with each installment.
Unlike the 1031 exchange, a Deferred Sales Trust offers versatility beyond real estate transactions. Through a DST, your asset is placed into a trust overseen by a third party. Serving as a trustee, this third party handles the sale of the asset and disburses payments to you over a pre-agreed period. During this time, capital gains taxes are deferred until you receive the installment payments. Notably, the trust can reinvest these funds, potentially generating additional income as you defer your capital gains tax obligations. This can also be particularly useful when the asset has significantly appreciated.
It’s important to note that while DSTs can offer a tax deferral advantage, they also involve careful planning and adherence to tax regulations. It’s advisable to seek guidance from an experienced New York 1031 lawyer to determine if this approach best fits your situation and facilitate the process.
Opportunity to conduct 1031 Deferred Exchange into Delaware Statutory Trust (DST)
In Rev Rul 2004-86 the IRS ruled that a taxpayer may exchange real property for an interest in the Delaware statutory trust without recognition of gain or loss under § 1031, if the other requirements of § 1031 are satisfied. In DST, the investor owns a fractional interest in a property instead of direct ownership and that fractional interest is managed by a sponsor. The investor takes a passive role in the property, while the sponsor handles landlord duties and other property management tasks. These sponsors are typically large real estate operators, some of whom manage multibillion-dollar publicly traded real estate investment trusts (REITs).
Qualified Intermediary Requirement
IRS regulations are very strict. A taxpayer cannot receive the proceeds or take constructive receipt of the funds in any way or the exchange would be disqualified. The use of a Qualified Intermediary is a safe harbor established by the Treasury regulations. The intermediary acts as a middleman to tie the sale to a buyer and the purchase from a seller as a verified exchange. The safe proceeds go directly to the Qualified Intermediary, who holds them until they are needed to acquire the Replacement Property. The Qualified Intermediary then delivers the funds directly to the closing agent. It is very important that the Qualified Intermediary is contacted prior to closing.
Time Requirements
A taxpayer is required to identify the target Replacement Property within 45 days of closing of sale. Properties acquired within the 45-day designation period are deemed to be identified. Replacement Property must be designated in a written document, unambiguously described, signed by the taxpayer and received by the Qualified Intermediary on or before the 45th day.
Within 180 days of closing of sale of the Relinquished Property, or before the taxpayer’s next tax return is due, the taxpayer must acquire the Replacement Property. These deadlines are absolute and cannot be changed or extended.
Common Mistakes
A 1031 Exchange is a great strategy to defer taxable gain on property but when setting up or completing a 1031 Exchange, taxpayers need to fully understand all the rules and procedures set forth in the tax code. Some of the most common mistakes that occur are:
1) Not looking for Replacement Property soon enough.
2) Not starting a 1031 Exchange on time.
3) Acquiring property from a related party.
4) Overfunding the loan on Replacement Property.
5) Using a disqualified party as a Qualified Intermediary or closing agent.
Avoiding mistakes, knowing how to take advantage of IRS Code section 1031and identifying if your property qualifies for 1031 and what type of deferred exchange works best for you is not easy to navigate. To get more information, get in touch with a New York 1031 Exchange attorney and have your legal questions answered. Contact Sishodia PLLC today online or by calling 833-616-4646 to learn more about your real estate investment options.
Natalia Sishodia, Esq. & Beatrice Raccanello, Esq.
All rights reserved by Sishodia PLLC. Attorney Advertising.
